ECB and Negative Interest Rates

The European Central Bank (ECB) recently announced that when banks now deposit money with them that it would pay -0.2%. In other words banks have to pay the central bank for the privilege of depositing money with them.

What is a negative real interest rate?
A real interest rate is the stated rate (2.5%) minus the inflation rate (2%) – real rate = 2.5% – 2% = 0.5%. As real rates fall it attracts more borrowing and less saving.

*Savers lose money each year to inflation
*Borrowing and consumption should rise.

Euro Zone – Interest rates 0.05%, inflation -0.6 = real rate of 0.65%

To get negative real rates, the nominal interest rate must be lower than the rate of inflation; if inflation is negative, the nominal interest rate must also fall below zero. As soon as the rate banks offer fall below that, savers have an incentive to withdraw their money and put it under the mattress. By charging negative rates the central banks are hoping that the trading banks will keep more of their money and therefore lend it out to investors. However the desire to reduce a banks reserves is futile as if someone borrows money from a bank and buys a new car the money is paid to the car company who will then deposit the money in their account which increases the reserves of the bank.

Central Bank Rates March 2015

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