More Harm than Good

The Eurozone inflation rate remains still low. Therefore, the European Central Bank (ECB) is likely to increase its large-scale asset purchase program on Thursday. Moreover, it is expected that the ECB will cut interest rates even further into negative territory. But negative interest rates will worsen the situation, according to a new study of the Cologne Institute for Economic Research (IW).

While the US Federal Reserve Bank will likely increase the Federal Funds Rate in December this year for the first time since June 2006, the ECB will most probably ease its monetary policy stance even more. In fact, both central banks are challenged by inflation rates below their target values, which made it difficult for them to increase their policy rates in the past. While the US labour market improved insofar that inflation and interest rates will normalize soon, Eurozone inflation is stuck near zero percent and the labour markets in many Eurozone countries are far away from a sustainable improvement.

The ECB has one additional problem: The bank loan supply does still not respond to the expansionary monetary policy. A low demand for loans explains only part of the story, so the IW study. Rather it is the bank capital requirements regulation which forces the banks to hold more equity capital in relation to their risk-weighted assets which restricts lending to the economy. The easiest way for banks to fulfil the higher capital requirements is to reduce their lending to the economy, while increasing their lending to Eurozone sovereigns. In contrast to loans to corporations sovereign debt exposures are treated as riskless in bank regulation.

„For credit to normalize, sovereign debt should no longer be privileged”, says IW-director Michael Hüther. Moreover, it is the profitable banks which maintained lending to the economy. Negative central bank interest rates will depress their profitability and thereby their loan supply: „A negative interest rate policy is counterproductive.” And in addition to that, persistent low or even negative interest rates cause great dangers for savings and for old age provisions.