This Is the Real Point of Europe’s Negative Rates

Banks and insurers don’t like it, borrowers are seeing little or no benefit from it and savers and pensioners fear their money is being eaten away by it: The policy of negative interest rates is as unpopular as it is mysterious.

The European Central Bank looks likely to cut rates further into negative territory this week and yet no-one really knows exactly how it is supposed to help.

The banal answer is that the aim is to stoke inflation from its current level of minus 0.2% toward the ECB’s target of below, but close to 2%. But inflation alone is also the most important answer even when there is evidence that negative rates are failing to stimulate growth through lending and that competitive currency devaluations don't last.

Inflation is a vital part of the effort to reduce the heavy burden of debt in European economies. This applies most obviously to the strained government finances of southern Europe, which are vulnerable to another downturn, but also relatively high private-sector borrowing in countries including France, Belgium and the Netherlands.

In the simplest terms, debt effectively stakes a claim on economic activity in the future: inflation means that each hour worked or each product sold in future will eat away a larger chunk of debt that exists today. That leaves more income to use for consumption or investment.

So, inflation and nominal economic growth could be more important than real economic growth, at least in the near term.

The reality is that, while real growth might be stimulated through more lending, this isn’t happening because negative rates are hurting bank profitability.

The longer interest rates stay negative, the worse the effect on bank profits is likely to be. Earnings on their bond portfolios will fall, or even become a cost.

Europe is in a bind and negative rates aren’t helping sluggish growth. But the policy could still help inflation by driving people and companies to spend their cash, thereby increasing the velocity of money, or by lifting expectations of inflation. And the alternative, were the ECB not to act, is to risk tighter financial conditions that make the target even harder to achieve.

What is clear is that without a pickup in inflation soon it is hard to see how Europe can escape from the dead weight of its debt burden.

Read more:

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