ECB Approaches Zero Rates by Stealth With New Weapon

By Jana Randow

March 12 (Bloomberg) -- European Central Bank President Jean-Claude Trichet’s new weapon to battle the recession is taking him closer than it seems to zero interest rates.

Trichet is allowing the ECB’s deposit rate, which lenders earn on overnight deposits with the central bank, to usurp the benchmark refinancing rate and become the main driver of short- term borrowing costs. At just 0.5 percent, the deposit rate matches the Bank of England’s key setting and is only a step away from the zero-to-0.25-percent range the Federal Reserve uses.

That is pushing interest rates for banks down, helping Trichet answer critics who accuse him of not doing enough as the euro-region economy sinks into its deepest recession since World War II. The deposit rate is “very, very low,” Trichet said three times in an hour at a press conference on March 5.

He “is implicitly admitting that the deposit rate has now become the key barometer of the ECB’s policy,” said Nick Kounis, chief European economist at Fortis in Amsterdam. “The ECB has become more and more comfortable in pointing that out, not least because it’s been accused of keeping interest rates too high.”

The euro overnight index average, or Eonia, fell to 0.85 percent yesterday after the ECB’s latest rate cuts took effect -- about 0.7 percentage point below the 1.5 percent benchmark rate. Overnight deposits dropped to 56.3 billion euros, the lowest amount since Oct. 8.

Unlimited Cash

The ECB’s decision to offer banks unlimited amounts of cash, announced on Oct. 8, has culminated in the deposit rate setting the new de facto cost of short-term money. The move removed the need for banks to borrow in the money market to meet their reserve requirements.

Banks have been reluctant to lend to each other since Lehman Brothers Holdings Inc. went bust on Sept. 15, preferring to stash excess money with the ECB instead of taking the risk.

As demand dried up, interbank-lending rates dropped toward the deposit rate. The Eonia rate averaged 106 basis points above the deposit rate in the seven years before the ECB started providing unlimited liquidity in October. Since then, the gap has shriveled and yesterday stood at just 35 basis points.

Unlimited cash “results in refinancing costs for banks well below the current benchmark interest rate,” ECB council member Axel Weber said on March 5. “We expect banks to pass this on to consumers and companies to stimulate the economy.”

Boost for Economy

The overnight Eonia rate “is a very important starting point for all market expectations,” said Julian Callow, chief European economist at Barclays Capital in London. “Any further reduction in Eonia expectations would lower Euribor rates and so be a considerable benefit for the real economy.”

The euro interbank offered rate, or Euribor, that banks say they charge each other for six-month loans dropped to a record low of 1.8 percent yesterday. Market rates of the same maturity traded at 2.08 percent in the U.K. and 1.93 percent in the U.S.

While Trichet hasn’t ruled out further rate cuts, officials are hesitant to go much lower. There is “no reason to see the refinancing rate below 1 percent,” Weber said on March 10. “I also see a problem with lowering the deposit rate to zero. I would prefer to leave it at 0.5 percent.”

That reticence may be linked to Japan’s experiment in the 1990s, when it lowered its key rate to zero to revive its economy in what became known as the “lost decade.”

Japan shows that keeping rates too low for too long “will cause interbank trading to run dry, despite the ECB’s efforts to revive it,” said Michael Schubert, an economist at Commerzbank AG in Frankfurt.

‘Excessively Low’

Some ECB officials are concerned that too-low market rates will become counterproductive because they will sap banks’ returns and give them less incentive to trade with each other. That would undermine the ECB’s aim to revive interbank lending through its unlimited liquidity operations.

“If we had excessively low interest rates, why would banks start lending to each other?” ECB council member Yves Mersch asked March 10. “It would be much safer to put their excessive funds into the central bank rather than engage in the interbanking market.”

The ECB has cut its main refinancing rate, which is used as a benchmark in money-market operations, by a total of 2.75 percentage points since early October. That is still well above the key rates of the Fed and the Bank of England, which have started buying assets such as commercial paper and government bonds to ease credit tensions and boost their countries’ economies.

Not so Different

So far, the ECB is focusing its efforts on providing unlimited liquidity to banks and said on March 5 it will provide these funds until at least the end of the year.

“With the extension of providing unlimited liquidity, the ECB committed to keep the overnight rate very low for the foreseeable future,” said Jacques Cailloux, chief euro-area economist at Royal Bank of Scotland Group Plc in London.

That is allowing Trichet to argue “that the ECB does not have such a different monetary-policy stance from the Fed and Bank of England,” said Gilles Moec, an economist at Bank of America Merrill Lynch in London.

He is “driving home the point that the ECB is doing much more than people think.”

To contact the reporter on this story: Jana Randow in Basel at jrandow@bloomberg.net