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ECB Zero Deposit Rate: Laboratory Experiment

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I think that the Fed is going to be watching the results of this ECB initiative closely.

Previously, many in the US have suggested that one way for the Fed to provide monetary stimulus would be for the Fed to cut the rate it pays for deposits to zero. Since US banks have over 1 trillion in excess reserves deposited at the Fed, the idea is that those banks would "do something" with the money rather than receive a 0% return.

I think that that the outcome of such a policy is very much open to question. Preliminary indications from Europe are that this policy may not work. Many banks appear to be choosing to de-leverage (e.g. stop taking client deposits and/or charging for the privilege of holding them).

It is far from clear that under current conditions banks will be willing to take on additional risk in order to earn 0.25% (what they are now earning on reserves deposited at the Fed). Banks may simply opt to deleverage — I.e. They will reduce liabilities by means of two mechanisms. First, they can simply withdraw the deposits that they hold at the Fed and pay back their creditors (depositors) — mainly the Fed itself that they are getting funds from at 0%. Second, they can reduce their deposits (liabilities) by lowering the interest rate that they pay clients. Indeed, they could even start paying negative interest rates on deposits (i.e. charging to hold money) in order to get their liabilities down.

It is far from clear that reducing the interest rate that the Fed pays its depositors down to zero will cause financial institutions and/or money market investors to go out on the risk spectrum and invest in riskier assets. It is just as likely that banks will de-leverage rather than take on more risk thereby causing a neutral or even contractionary effect on systemic liquidity. The net liquidity effect could be contractionary if the overall demand for USD assets were to contract as a result of low rates and generalized expectations of a concomitant devaluation of the USD.

It is also possible that such a move could push investors to invest in foreign money market assets or even gold. The rise of the USD relative to the Euro in recent days may be partially attributable to investors fleeing nill to negative "safe" yields in Europe and seeking positive USD yields. It is unclear whether the search for yield could push European investors out on the duration spectrum to chase longer duration sovereign debt yields. There is no indication so far that this is really working in a way that benefits Europe. It's early days, though.

The point is that this bears watching. I don't think anybody really knows how this will end up playing out. But what the ECB is doing creates a substantial wild-card in terms of global monetary dynamics.

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