Key ECB Stimulus Tool Is Put on Trial for Creating Problems

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The European Central Bank is approaching the point where it needs to decide whether if negative interest rates are more problem than solution.

Since officials pushed back plans to tighten policy, warnings have increased that the potency of a key instrument used to rekindle growth in the 19-nation bloc is diminishing the longer it remains in place. France’s Francois Villeroy de Galhau, formerly of BNP Paribas SA, is loudest in voicing concern that sub-zero rates may prevent stimulus from reaching the economy because they’re hurting bank profitability.

Declining Margins

Euro-area banks have seen profitability declining with ECB easing policies

Source: ECB

Note: Chart shows mean response to survey question on impact of cost of funds and balance-sheet constraints on margins, with 1=contributed considerably to tightening and 5=contributed considerably to easing.

The argument isn’t unique to Europe. Banks in Japan are urging policy makers to watch that negative interest rates aren’t causing side effects, and officials at the Federal Reserve, which has never used the measure, argue it could cause problems for the U.S. financial system.

In the eyes of ECB President Mario Draghi, sub-zero rates “have been quite successful” — reason enough to examine whether mitigating measures may be needed to ensure they remain a worthwhile tool.

Fueling the debate is an academic concept that describes how at some point low borrowing costs start to harm rather than help the economy. The euro area may be on the cusp of it, according to Markus Brunnermeier, an economics professor at Princeton, who pioneered the idea of the reversal rate.

“Going negative was not a bad choice for the ECB,” he said in an interview. “But you have to figure out how long you want to stay low because the reversal rate tends to creep up and you may need measures to slow it down.”

While Brunnermeier isn’t advocating a rate increase, he argues that policy makers could consider following Switzerland’s example, where only reserves above a certain level are penalized.

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