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ECB's interest rate decision IW News 21. July 2016

Europe needs higher interest rates

The council of the European Central Bank (ECB) has decided to maintain a negative interest rate for banks at -0.4 percent. Low or negative interest rates, however, have not fostered economic growth yet. Instead, they have reduced banks’ profits, why bank lending to companies is still weak. Thus, the time has come for an interest rate hike.

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Bank lending in the Eurozone still grows at a very slow pace and the Eurozone's inflation rate is still below the ECB's inflation target. Negative interest rates and the ECB's large-scale asset purchases are intended to foster economic growth – but both worked only with minor success yet. The reason for this is that the traditional theory, that lowering interest rates fosters economic recovery, is not valid anymore. On the contrary, it needs higher interest rates in the current situation to stimulate the economy.

Banks are hesitant to lend to enterprises at the moment because they have to fulfil higher capital requirements. In normal times, they can issue stocks to increase their capital base. But the prices of bank stocks are currently low, why banks cannot raise enough money by issuing stocks. And the low interest rate environment has led to shrinking profits, why banks have a hard time in strengthening their capital base by retaining profits. Thus, the ECB's negative interest rates impede bank lending – which leads to the opposite of the intended effect: Instead of lending money to productive investment opportunities, banks invest into negative yielding sovereign bonds. They do this because they can purchase sovereign bonds without raising their capital base and the lesser evil to holding their money as reserves at the ECB at a negative interest rate of -0.4 percent, is to hold slightly less negative yielding sovereign bonds.

A doom loop emerges in this situation: the high demand for sovereign bonds leads to even more negative yields, which lowers banks' profits even further, this hinders banks at strengthening their capital base, which weakens their loan supply and which increases banks' demand for sovereign bonds even further.

But if the ECB increases interest rates, it will help banks to strengthen their capital base, which will ease the current tensions in the market for loanable funds. This will have positive effects especially for long-term lending, from which small and medium-sized companies will benefit. Companies of this size are mostly affected by a restrictive bank lending: Since it is too expensive for them to issue bonds in capital markets they are dependent on a functioning banking sector.

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