ECB’s Limits of NIRP And Gold

While waiting for the interest rate decisions of the world’s major central banks and important economic data on U.S. retail sales and inflation, let’s further investigate the ECB’s press conference held after its last monetary policy meeting. What can we conclude from Draghi’s answers?

How Not to Communicate Monetary Policy

Perhaps the most important question asked on Thursday was the one about the limits of negative interest rates. Answering this very question, Draghi spoiled the party he had just organized himself for financial markets and said: “We don’t anticipate that it will be necessary to reduce rates further”. And he continued: “Does it mean that we can go as negative as we want without having any consequences on the banking system? The answer is no”.

This is a useful lesson for central bankers how not to communicate one’s monetary policy. Indeed, communication is nowadays at least as important as the action one takes. Let’s see what Draghi did. By expanding the quantitative easing, announcing the TLTRO and cutting rates, he signaled that the ECB has plenty of monetary policy ammunition. But just several minutes later he sent a message: “Oh, let’s think about it a few more seconds, maybe we do not have that many options?”

What Are Limits of NIRP?

Inquiring minds may ask why the ECB cannot go as low as it wants. Indeed, it is an interesting topic, especially that Draghi assured journalists that “the experience we’ve had with negative rates, in our case at least, has been very positive”. Yeah, if the experience was so excellent, the ECB would not have any doubts about going too negative or any doubts about the impact of NIRP on the banking system. In reality, it seems that the mortgage market and the Euro Interbank Offered Rate (Euribor) set a limit for NIRP. What is Euribor? It is the rate at which prime European banks offer to lend unsecured funds to each other in the euro market. Now, the trick is that many mortgages in Europe are based on Euribor. According to Mike Shedlock, the typical mortgage loan in many Eurozone countries is Euribor plus 1 percentage point. Thus, if Euribor rates fell below -1 percent (they follow the ECB cuts), banks would have to actually pay customers interest on their mortgages (the same applies, of course, to Libor and adjustable-rate mortgages in the U.S.). As Draghi pointed out:

“Some banks have a business model which exposes them to the negative rates more than other banks, if they have a structure for funding themselves such that it’s affected by negative rates more than other banks. (…) You have situations where deposit rates are set at the minimum by law, for example. To this extent, negative rates cannot be passed to depositors. (…) There are also other banks completely different, for example, that suffer from negative rates for another reason. They have a funding structure that adapts pretty well to the negative rates, but on the other hand, they have given their mortgages and loans, often, that are indexed to the Euribor. As negative rates bring down into negative territory the Euribor, you see that their mortgages go to produce a loss unless the spreads are sufficiently high, which is not always the case.”

Did Central Banks Fall into Trap?

Draghi also explained why the ECB had not introduced a tier system associated with NIRP, as the Bank of Japan had – he said that this was for the purpose of not signaling that the ECB can go as low as it wants. Yes, you read it correctly. The ECB did not want to create an impression that it is not constrained in its actions. Simultaneously, Draghi pointed out several times that the ECB is not short of ammunition. Mr. Draghi, please decide: either you can go as low as you want, or there is a floor when you lose the ability to further manipulate interest rates. Thus, it seems that the ECB fell into a trap. It did not want to signal that it could go as low as it wanted, to not generate fears about the impact of NIRP on the economy, but it also wanted to deny the perceived lack of power of central banks. It failed to achieve both goals.

Conclusions

The bottom line is that investors are realizing that there are limits to what central banks can do. The ECB is rapidly approaching them and, without real structural reforms, it can merely buy policymakers some time. Surely, with Euribor at -0.3 percent, Draghi has some buffer, but the floor is close. The reactions after his press conference suggested that he lost the investors’ trust. The reduced confidence in the central bankers is bullish for the yellow metal. The crucial question for the gold market is whether the diminished trust in the world’s major central bank is only a short-term mood or a long-lasting shift in the investors’ minds.

Disclaimer: Please note that the aim of the above analysis is to discuss the likely long-term impact of the featured phenomenon on the price of gold and this analysis does not indicate (nor does it aim to do so) whether gold is likely to move higher or lower in the short- or medium-term. In order to determine the latter, many additional factors need to be considered (i.e. sentiment, chart patterns, cycles, indicators, ratios, self-similar patterns and more) and we are taking them into account (and discussing the short- and medium-term outlook) in our trading alerts.