ECB dances in the dark | FT Alphaville

ECB dances in the dark

As expected the ECB has cut its main refinancing rate by 25 basis points to 0.75 per cent and the marginal lending facility (emergency funds) by 25 basis points to 1.50 per cent.

In a less expected move they also cut the deposit rate to zero.

Here’s the statement:

At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:

The interest rate on the main refinancing operations of the Eurosystem will be decreased by 25 basis points to 0.75%, starting from the operation to be settled on 11 July 2012.

The interest rate on the marginal lending facility will be decreased by 25 basis points to 1.50%, with effect from 11 July 2012.

The interest rate on the deposit facility will be decreased by 25 basis points to 0.00%, with effect from 11 July 2012.

The President of the ECB will comment on the considerations underlying these decisions at a press conference starting at 2.30 p.m. CET today.

There was a bit of speculation previously that they might even cut below zero to negative territory.

While negative rates on deposits have been avoided for now, it’s clear the ECB has gone into experimental mode.

As someone commented on Bloomberg TV just before the decision, it is increasingly obvious that the main refinancing rate is no longer the most important rate for the economy. That is now the deposit rate, since it helps to keep banks ticking over in terms of positive carry.

In other words it ensures that money does not depreciate.

And with no incentive to lend, this is the best bet for bank profitability at the moment.

This has not been the case for non-banks, which have had no such luxury. The oversupply of money in the system is already causing negative return problems for them. This could make things worse.

As Bloomberg noted last week:

On the other hand, a deposit rate cut could hurt banks’ profitability by lowering money-market rates, potentially hampering credit supply to companies and households and reducing banks’ incentive to lend to other financial institutions.

We actually think this is a bit of a misunderstanding. A positive deposit rate was the last thing anchoring money market rates to zero — or vague profitability. This is because banks could arbitrage the difference between the rates they received at the ECB and the rates money market funds were able to invest at.

By cutting the deposit rate, the ECB is killing this arbitrage. There will not be any profit associated with taking money from non-banks and parking it at the ECB for a small profit. Non-banks won’t even be able to get zero.

This will leave real-rates exposed to further deterioration.

The ECB, of course, is hoping that non-banks will choose to channel that money into risky assets instead…

We’ll have to see if this in fact happens, or if non-banks opt to continue to crowd each other out and suffer principal loss. Or possibly take their money outside of the euro system altogether.

Related links:
Pariah profits in an age of ‘negative carry’ – FT Alphaville