Move Over ZIRP, Welcome NIRP

Posted in: Economics, General, Stock Market, Thought of the Week

The Fed has maintained a Zero Interest Rate Policy (ZIRP) for over five years in order to help our economy from the damage caused by the financial crisis. The goal of ZIRP is to entice companies to borrow cheap money to hire workers and grow their businesses. Last week, the European Central Bank (ECB), which is the central bank for the Eurozone, announced that they will be charging banks in the Eurozone a 0.10% interest rate to keep deposits with the ECB.

The bank’s goal is to earn a “spread”, which is the difference between the small business loan revenue of 5% and their cost to the depositors of 1%. Simply put, the bank wants to get as many deposits as possible because the more depositors that a bank can attract, the more money they have available to loan out to collect the spread. For instance, if the economy is slow, then the bank will offer a lower interest rate because they are not loaning as much money out to small businesses, etc.

Currently, the ECB measures inflation in the Eurozone to be approximately 0.5%, which is far below the bank’s goal of 2.0%. Some inflation is actually a very good component to a healthy economy because it signals that demand for goods exceeds supply. Demand can only be high if the economy is strong and consumers and businesses are spending money. If inflation continues to decline towards zero, then an economy can succumb to the gravitational pull of “deflation”. This is a scenario where prices for goods begin to decline, and as appealing as it may sound to pay less for goods, deflation is a very serious problem for an economy for three key reasons:

  1. Save Instead of Spend: Consumers would rather save their money when prices are falling because goods cost less in the future than today. Given that consumer spending represents 70% of a developed country’s economy, recessions can occur quickly when consumers stop spending.
  2. Debtors Get Hit: If deflation is occurring in an economy, wages will also likely fall. Those consumers and businesses that must pay interest and principal on existing loans now have a bigger burden to face as their debt becomes more difficult to pay off since their interest payments remain fixed but their income is declining.
  3. Hard to Fix: Deflation is a real problem because central banks have limited ability to fix a deflationary environment. Japan endured two decades of deflation until last year when their central bank took drastic measures to attempt to reverse course.

The ECB is acutely aware of the risk of deflation, and they instituted NIRP to prevent any further move in that direction. By charging banks to keep money deposited at the ECB, they are trying to incentivize these banks in the Eurozone to loan money to businesses and individuals. Cheap loans should cause businesses to hire new workers and buy new machinery, and consumers can get cheap mortgages and loans to buy new automobiles, etc. As the demand for these goods rise, inflation should kick in and ease the threat of deflation.

The world is much more integrated today than a decade ago, so what happens in Europe impacts investors here. Our Investment Committee does not anticipate Europe falling into a deflationary environment because the ECB has many more tools at their disposal if their NIRP fails to spark inflation. Although Europe is not as far along in their recovery as the U.S., they are moving in the right direction and the ECB will likely do whatever it takes to ensure the survival of the Eurozone.

Read this week’s Thought of the Week to learn more about the Negative Interest Rate Policy in Europe.

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As an Investment Advisory Representative working in conjunction with Global Financial Private Capital (GFPC) we are provided weekly thoughts on what is happening in the economy and the market. Written by our investment committee at GFPC we find these thoughts to be informative and interesting.