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The Weekly Economic & Market Recap    

February 22, 2019  

Almost a full five years ago, the European Central Bank lowered its deposit facility rate to a -0.1% embarking on a negative interest rate policy (NIRP). Negative interest rates are an unconventional policy tool that essentially charges European banks to hold reserves at the ECB which encourages banks to lend more. Negative rates, in theory, dissuade businesses and consumers from keeping cash and encourages both consumption and investment. The ultimate intention is to stimulate economic activity and raise economic growth. The Bank of Japan announced a negative interest rate approach as well in January of 2016. Over $11 trillion worth of bonds in Japan and Europe currently carry a negative rate of interest. The transmission mechanism between interest rate changes, the level of interest rates and economic effects in the real world is complicated. Investor and consumer behavior are affected by numerous factors and not just interest rates. Additionally, when rates are negative, the market participants’ behaviors change depending on the length of time rates stay below zero. As negative rates persist, the market will ultimately interpret NIRP as a drastic measure that indicates the central bank is afraid that the economy is at risk of falling into a deflationary spiral. Due to low returns in an aberrant rate environment, investors become concerned that savings will not grow enough for future needs and they increase savings. So NIRP eventually has the opposite effect that the policy intended. It can also weaken the banking sector over time. Banks generally are liability sensitive and they feel constrained by the zero-bound rates. Thus, bank lending actually decreases as margins are squeezed. With NIRP and the astounding expansion of the ECB’s balance sheet, it is concerning how anemic economic growth has been in Europe and inflation expectations are well anchored below 2%. Some countries such as France and Italy, that have experienced GDP growth averaging 0.8% and 0.5%, respectively, since the end of the Great Recession, are hurting and seeing rising political unrest. It is perhaps unfair to say that the negative interest rate experiment has been a failure, but NIRP has not worked as Europeans had hoped. The ECB has also effectively lost its primary tool to combat the next recession.

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