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5 July 2012

QE, zero rates, and a Chinese surprise

It's central bank mania!

By Alex Hern

It’s central bank day, and for once all three reporting banks – the Bank of England, European Central Bank and Bank of China, which for the second month in a row announced its decision after the Bank of England – have done something interesting.

The Bank of England announced, as expected, that it would be increasing its quantitative easing program by a further £50bn. In the accompanying statement, it struck a sombre note:

UK output has barely grown for a year and a half and is estimated to have fallen in both of the past two quarters. The pace of expansion in most of the United Kingdom’s main export markets also appears to have slowed. Business indicators point to a continuation of that weakness in the near term, both at home and abroad. In spite of the progress made at the latest European Council, concerns remain about the indebtedness and competitiveness of several euro-area economies, and that is weighing on confidence here. The correspondingly weaker outlook for UK output growth means that the margin of economic slack is likely to be greater and more persistent.

The new round of asset purchases will also have been encouraged by the consistently falling inflation. Textbook QE raises inflation, and although the economy isn’t behaving according to many textbooks these days, the Bank will still have wanted to wait until it was within spitting distance of its mandate before acting.

Minutes later, however, the Bank of China stole some of the shine, by cutting its interest rates for a second month running. It lowered its benchmark interest rate by 0.25 per cent, and also lowered its one-year lending rate by 0.31 per cent.

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Business Insider’s Sam Ro sums up why that matters:

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China’s growth rate has been decelerating lately, which had some economists concerned that its economy would land hard. In a hard landing, the unemployment rate picks up and the economy risks sinking all the way into recession. China is the second largest economy in the world. And for most economies, China is also the main source of growth.

Falling interest rates could mean that the Chinese central bank is starting to get edgy.

Finally, an hour ago the ECB announced its monthly move on interest rates. And they went for some unconventional monetary policy! Admittedly, not as unconventional as paying for people’s holidays: they lowered the deposit rate to zero per cent (as well as cutting its main refinancing rate to 0.75 per cent and the emergency funds rate to 1.50 per cent). If you park your money with the central bank, they won’t give you a penny cent.

Alphaville’s Izabella Kaminska explains the reasoning:

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…

With the deposit rate where it is, the ECB has well and truly reached the zero bound. The only way down now would be to ban money. Their call, it seems.