Deflation Alert--Negative Interest Rates

In an effort to force banks to lend money, the European Central Bank is going to head into mostly unknown waters--negative interest rates. Explains Neil Erwin at the New York Times:

... Commercial banks maintain their reserves electronically at a central bank, like the Federal Reserve in the United States or an arm of the European Central Bank in Europe. In normal times, they are paid an interest rate set by the central bank for reserves they keep on deposit beyond what is needed to meet regulatory requirements. If the E.C.B. moves to a negative interest rate, they will instead have to pay the central bank to park money there. 

Put bluntly: Normally the banks pay you to keep your money there. Under negative rates, you pay them for the privilege. 

... The theory is that when it becomes more costly for European banks to keep money in the E.C.B., they will have incentive to do something else with it: Lend it out to consumers or businesses, for example. Or if negative rates make it less attractive for global investors to park money in Europe, it could cause the euro to fall on currency markets, helping reverse a rise in its value that has made European exporters less competitive. 

... Banks will most likely pass these negative interest rates on to consumers, or at least try to. They may try to do so not by explicitly charging a negative interest rate, but by paying no interest and charging a fee for account maintenance. 

... On the other hand, if the interest rate is only slightly negative, banks may just eat the loss in order to avoid alienating customers. If they do that, however, it will cut into bank profitability.

The article goes on to note that one result could be that people will simply withdraw their money from the bank rather than pay the fees. Denmark went into negative territory a couple of years ago, and although it did not cause widespread withdrawals from banks, it also didn't help the Dutch economy. One suggestion is to eliminate cash, which would remove the floor on "negative interest" because money would have to be retained in banks.

This article notes that the results--if it works--could result in banks dumping large amounts of pent-up reserves into the money supply and spur inflation.

See also here and here.

I would note that the European banking situation is somewhat different from the U.S., where quantitative easing (Q.E.) has been used.

I also recommend this article on how China is "exporting" deflation by devaluing the Yuan to prop up exporters:

The US Treasury clearly suspects that the Chinese authorities have reverted to their mercantilist tricks, driving down the exchange rate to keep struggling exporters afloat. Officials briefed journalists in Washington two weeks ago in very belligerent language.
The Treasury’s currency report this month accused China of trying to “impede” the market by boosting foreign reserves by $510bn last year to $3.8 trillion – “excessive by any measure”. 

It gave a strong hint that China is disguising its reserve accumulation. You don’t have to dig hard. Simon Derrick from BNY Mellon said a recent buying spree of US Treasuries and agency debt by Belgium of all places looks like a Chinese front. 

Holdings by entities in Belgium have jumped to $341bn from $169bn last August. This would appear to explain how China’s FX reserves have kept rising to $3.95 trillion even as its custody holdings in the US itself have been falling. If so, China is playing dirty pool. 

Hans Redeker from Morgan Stanley says China seems to have adopted a “beggar thy neighbour policy” to counter the slowdown at home and soak up excess manufacturing capacity. 

Albert Edwards from Societe Generale said in a note today that China is “sliding inexorably towards deflation”. Factory gate prices have been falling for 25 months in a row. 

The GDP deflator – which proved a much better gauge of trouble at the onset of Japan’s Lost Decade than consumer prices – has plummeted from 1.4pc to 0.4 over the last year.

(H/t Infowars)