The European Central Bank made history this morning, becoming the first modern major central bank to institute a negative interest rate.
ECB president Mario Draghi announced the bank will reduce the rate on deposits to minus 0.10 percent from zero percent. The ECB’s main interest rate, the refinancing rate, is still positive—that rate was cut from a record low of 0.25 per cent to 0.15 per cent. But the move grabbing attention this morning is the decision by the bank to move a secondary rate, the rate paid on money deposited at the bank, from zero to minus 0.1.
This move will be closely watched. The decision to go negative on rates is a modern experiment in central bank that is, to put it mildly, "highly unusual.”
"The combination could prove a powerful cocktail that boosts bank lending," a banker was quoted as saying. “But negative deposit rates have not been used at this scale before and could have unpredictable consequences."
The ECB felt it had no choice. In the years since the Great Recession in 2008 the global economy has failed to re-start. Bankers are worried a serious bought of deflation is settling in. By cutting rates private banks will be charged to keep money at the central bank. The hope is that private banks will take their money out of the central bank and loan the funds out, kick-starting the economy. A lower interest rate will also lower the value of the Euro, making EU exports more competitive.
It will be interesting to see if the move works. The ECB considered this policy in the summer 2012. At the time Draghi suggested such a policy was a matter of heading into "largely uncharted waters." Negative interest rates have been attempted in smaller countries. Sweden and Denmark, both outside the EU currency union, have gone negative. But this is the first time a major central bank has done so. Advisors struggling to maintain the retirement plans of clients in a world of weirdly low interest rates will watch warily.
Many assumed higher returns on conservatively invested portfolios. Those assumptions are now turning out to be wrong as bond porfolios generate low returns makig it tough to finance a retirement. “There’s no yield out there,” says Jason Abbott, financial planner and principal of WEALTHDesigns.ca. “Bond funds lost money. Where's the real risk? If portfolio is making 2% but clients need to be taking 5%, well, there’s a problem there.” That central banks are now going negative in terms of interest rates is worrying.
The July issue of Wealth Professional will include a major feature on the challenge and solutions advisors face around a world of weirdly low interest rates.