Reversal rate not a threat to Europe says ECB

Bank lending unaffected by future cuts to interest rates

                                

The European Central Bank could slash interest rates even further before impacting on bank lending, according to a study by its top economists.

The report states that the reversal rate, which is the point at which banks cut back on lending to protect profitability, is still a long way off.

The paper looked at three hypothetical scenarios, with the bank’s deposit rate lowered to minus 0.5 per cent, minus 0.75 per cent or minus 1 per cent, at the start of 2019 and kept it at those levels for three years.

They found that “notwithstanding the erosion of banks’ income, the capacity of banks to create credit appears largely unperturbed in all scenarios.”

“On the face of it, these results seem reassuring,” the paper states. “The reversal rate might not be in sight in the euro area for still quite a while, at least over the range of levels for the overnight interest rate that we have considered in our simulations.”

The ECB cut its deposit rate to minus 0.5 per cent in September and policymakers have warned against taking it any lower, fearing it would it impede lending. However, this paper could prove otherwise.

The newly appointed ECB president has used the findings to her advantage. When asked about reversal rates at recent press conference she said there are no signs of credit beginning to contract, and spoke about a rise in household borrowing.

However, the authors of the ECB paper, which was led by Massimo Rostagno, the head of the ECB’s monetary policy decision, said “caution” must be taken when interpreting their figures.

“Our simulations are predicated on a pure monetary policy experiment, whereby the central bank’s easing comes as a surprise in an otherwise unchanged macroeconomic environment.

“But, in fact, it is hard to believe that a central bank would consider bringing its policy rates to such low levels in the absence of negative shocks having downgraded the prospects for the economy and inflation, relative to their expected constant-policy baseline evolutions.”

The reality is, an increased rate cut would be due to worsening economic conditions, which in turn would make lending riskier for banks.

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