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What Europe's move to negative interest means for investors

June 10, 2014

The European Central Bank (ECB) made a historic move on June 5, lowering a key interest rate below zero, to –0.10%. And while the direct effects may be muted—the overnight deposit rate had already been at 0%—the message was loud and clear.

Charles Thomas"The ECB is taking a forceful step to broadcast its unwillingness to tolerate deflation," said Charles J. Thomas, an investment analyst with Vanguard Investment Strategy Group. "Because expectations are crucial in determining inflation, such a strong statement itself reduces the likelihood that deflation will occur."

We believe investors should avoid the urge to make portfolio changes based on the ECB's actions. Forward-looking markets have historically tended to discount events before they happen, Mr. Thomas said, making it difficult to benefit from policy announcements, particularly in cases like this where some type of policy easing had broadly been expected.

What the ECB did

The ECB, the central bank for the currency shared by 18 European Union countries, lowered the rate at which it pays banks for their overnight deposits of reserves. Because the rate became negative, banks now will have to pay a small interest rate—0.1%—to keep their reserves safe at the ECB.

"The idea is to create an incentive for banks to instead lend their funds to the broad economy, which drives economic growth," Mr. Thomas said. "While this negative-rate policy may seem extreme, in reality it provides only a slight change in trade-offs for banks when evaluating their decision to either hold reserves or create loans."

The deposit rate represents the "floor" among three key policy rates that the ECB uses as a target range for broad money market rates. In reducing all three rates on June 5, the ECB lowered this target range about as low as it can go.

The ECB's moves are similar to some undertaken in recent years by the Bank of England and the U.S. Federal Reserve. These central banks have kept interest rates at record lows using communications and policy adjustments as a way to signal what they might do next. But unlike the ECB they have also engaged in "quantitative easing," the purchase of government securities to increase the money supply. The Fed has scaled back its purchases amid signs of an improving U.S. economy.

The ECB has not yet embarked down the path of asset purchases, but its president, Mario Draghi, acknowledged that interest rates had now reached their "lower bound." The ECB also took steps to promote lending with a new program to provide banks with cheap financing tied directly to their loan creation. And it said it would intensify preparations for purchases of asset-backed securities, a program that could ease borrowing conditions for small and midsize businesses.

Will the measures work?

Critics of such policies point to the prospect of runaway inflation. But deflation is the ECB's greater concern at the moment. In fact, Mr. Thomas said, it's not clear how effective the ECB's measures might be.

With households and businesses facing poor growth prospects in a tough European economy, banks lack sufficient attractive borrowers. And many creditworthy consumers and businesses may not want to borrow at all, focusing instead on debt repayment. So the availability of loans may not be the issue. "The ECB can try to promote the supply of lending by providing banks with access to cheap financing," Mr. Thomas said, "but the real issue is whether the demand for loans from creditworthy borrowers is there."

Still, he said, while the practical effect of the move may be limited, "The introduction of a negative rate could be a powerful cue to the marketplace that the ECB is willing to take unprecedented measures in its efforts to combat deflation."

The effect could be similar to when Draghi said in the summer of 2012 that the ECB would do whatever it took to save the euro. That statement alone, absent real action, was enough to reduce yields in peripheral nations trying to stay afloat.

Why deflation matters

Deflation is a general decline in the prices of goods and services. "When deflation is in play, goods and services are continuously going on sale," Mr. Thomas said. "Consumers and businesses hold back on purchases in anticipation of lower prices, which leads to recession."

The falling wages and revenue associated with deflation make it more difficult for governments, households, and businesses to reduce debt.

The risk that deflation expectations would become embedded in the economy is significant in an environment of 0% interest rates and extremely low inflation, Mr. Thomas said.

Annual inflation in the 18-nation Eurozone fell to 0.5% in May from 0.7% in April, according to Eurostat, the European Union's statistical office. It had also been 0.5% in March, but hadn't previously been that low since November 2009, in the midst of the global financial crisis. The ECB has a medium-term inflation target of below but close to 2.0%.

Implications for investors

"One way that investors can help mitigate the risk and uncertainty associated with economic developments in any one region is to make sure they have broad diversification by owning a little bit of many investments across the world," Mr. Thomas said. "And investors would be wise to remember that they generally are rewarded over time for the risk they take in their portfolios, not for day-to-day economic events.

"By focusing on things within their control—having clear, appropriate investment goals and a suitable asset allocation, minimizing costs and maintaining perspective and discipline—investors will give themselves a chance for long-term investment success."

Notes:

  • All investments involve some risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
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