99 Draghi trial balloons [updated] With some header credit due to Mark Dow He came, he cut, he stuck a load of fingers in the air... The tl;dr version of May's Draghi presser involved the ECB chief mentioning a heap of possible actions - from getting the "dead" ABS market going to help SMEs, through to negative interest rates, while giving a little bit of forward guidance on policy - but without committing to anything concrete. Or as Citi's Steven Englander put it: The correct interpretation is that investors viewed the rate cut as a prelude to further measures that would help lower peripheral rates at the long end and stimulate activity - ie. the much-rumored program to help finance SMEs at lower rates. The rate cut initially raised the perceived odds of these further measures that could provide stimulus to euro zone economies, particularly those at the periphery, Instead we got a balance view of inflation risk, a non-unanimous rate cut, a declaration once-again that the ECB is not in the business of monetization, and an extremely vague comment on SMEs and hand-off to other institutions. Reasonably dovish but vague stuff. On one point at least, Draghi had his trial balloon swiftly popped. After saying the ECB had an "open mind" over whether to introduce negative interest rates, the euro did this against the dollar: Draghi's reference to the option was decidedly less negative than previous mentions by Peter Praet, for example [updated with this point] and as Deutsche's Alan Ruskin said, may have been a form of verbal fx intervention (our emphasis): The ECB press conference will be remembered for a single quote that "the ECB has an open mind on negative deposit rates." The crucial question is: how will a negative depo rate help the real economy? Let me jump to the conclusion: primarily through the exchange rate (the relative price of money), less through the absolute price of money (interest rates), and much much less through the quantity of money (credit/money supply). Draghi knew exactly what he was doing and it is very likely that keeping the door open on negative deposit rates, was more than a way of saying we are keeping all our policy options open, and was one of the few ways Draghi could significantly impact the EUR. Draghi has consistently suggested that credit is primarily delivered in the EUR area via banks, so how does a negative depo rate help the credit process and by extension the monetary expansion process? The credit process may well be impaired initially by negative rates, as liquidity shifts out the curve, and short-term sources of funding become less available. A key aspect of bank lending is term mismatch - borrowing cheaply short-term and extending term lending out the curve, but this becomes much more difficult if sources of funding "prefer their mattress" and are less willing to provide s/t funds, under a negative rates regime. I have heard arguments made against negative rates, that the EUR area is not Denmark or Switzerland, because it is not faced with excessive capital inflows. However, if the EUR is perceived as too strong, this is in some ways an "excessively strong balance of payments story" of a more subtle form, that the ECB seems more willing to "manipulate" through verbal intervention. In contrast, an actual shift to negative rates is extremely heavy handed, with repercussions difficult to fine-tune, so the easier approach is to keep the negative depo rate as a source of verbal intervention, directed in no small part at the exchange rate. We've covered negative interest rates in some detail already. Hell, we even asked Draghi about it last time we snuck into the ECB. So it might be best to quote the below from an earlier post by Izzy, direct you to some links... and point out once again that negative rate mentions by the ECB fall firmly into "could well be a straight up bluff to get cash moving like a hot potato in the eurozone" territory: According to traditional central bank logic, if negative rates are lower than what private markets are charging each other, this should be enough to inspire lending rather than central bank hoarding. But two problems remain. 1) While lending might finally start, it would do so in the context of an official negative regime. In the current climate that would officially legitimize money decay - and take away the last remaining safe positive yield from the market. From a market psychology point of view, not only does this create the prospect of a Japan deflation scenario unfolding, it would destroy the entire banking model with it. Banks cannot really survive in a negative carry universe. There is also the very real chance it would send bond yields much deeper into negative territory - creating a capital destruction spiral that will only accelerate negativity and deflation. 2) Central banks lose control in a world of negative rates. This is because negative rates can never truly encourage lending at lower rates the way that lower - but still positive rates - usually can, not overcome the hoarding problem. This is all due tothe cash option. Ordinarily when the bank cuts rates below the private market rate, the cash option is not a threat at all. After all, would-be lenders must now compete with the lower central bank rate for business, and there is no advantage associated with hoarding cash at a lower rate at the central bank? Why wouldn't private rates comply and follow lower? With negative rates, however, there is a natural block to lenders. After all, why would you pay anyone to borrow from you when you can simply hoard cash at zero? Second, why would you continue to hoard cash as excess reserves at the central bank at a negative yield, if you can transform it into cash and keep it in a vault for zero (minus storage costs)? Which means that for as long as the cash option exists, negative rates either encourage outright capital flight offshore (to positive yielding territories) or encourage cash hoarding in vaults. None of these do much for lending. Hence why the threat of negative rates is currently a much more powerful tool at the moment than their actual deployment - a way of basically saying to the banks, "start taking risk and lending or else we'll destroy your entire business model." Not to say that the deployment of negative rates in the long run isn't unavoidable. Just that if it is to work, it will need to be associated with a cashless society, a meticulously managed taxation system or the introduction of some sort of decaying money coupon. And another nice explanation by Capital Economics: The main aim of negative rates would be to boost lending to the wider economy. The move would not cause a mechanical drop in aggregate bank reserves with the ECB. After all, if one bank lent to a firm, the money would probably end up in that firm's commercial bank account and then back in that bank's account with the ECB. But negative deposit rates should encourage banks to find ways to make profits with their money (i.e. opportunities to lend) instead of just paying to leave it on deposit. But there are two big problems with this theory. First, even if banks in the euro-zone were very keen to lend, there is no guarantee that they could do so. The ECB's October Bank Lending Survey revealed that weak demand for loans was a bigger factor holding back lending than a lack of supply. Second, banks might well be prepared to pay for safe deposits with the ECB instead of making loans that they fear will never be repaid. Note that demand for safe assets such as German and Swiss short-term government bonds has already driven the yield on these assets into negative territory. Beyond having dubious positive effects, negative deposit rates might even be damaging. If banks were unable to lend more to boost their profits, they might look for other ways to offset the cost of depositing money with the ECB. This could mean an increase in lending rates for existing borrowers. Related links: The base money confusion - FT Alphaville Why negative interest rates are a bad idea, by Capital Economics - FT Alphaville The negative rate bluff - FT Alphaville On negative interest rates and hoarding - FT Alphaville The "natural experiment" of negative deposits rates in Denmark - FT Alphaville Negative rates as a precursor to the death of banking - FT Alphaville World watches as Danes venture below zero - FT Draghi open to negative deposit rate trumps rate cut to drive euro lower - Credit Writedowns (Chandler)