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ECB cuts rates below zero to boost eurozone economy

AFP

The European Central Bank cut interest rates to record lows on Thursday, imposing negative rates on its overnight depositors to cajole banks into lending more and to fight off the risk of deflation.

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The cut, the first time the ECB has deployed a negative deposit rate was a response to both a slowdown in inflation far below the ECB’s target and to weak eurozone lending.

That is a combination that risks dragging the bloc into an economic quagmire.

Q: What does it do?

A: The ECB was created by the Treaty of Maastricht, the basic treaty setting up the European Union. The treaty, which came into force in 1993, called for a single currency and a single central bank as a way of creating a closer economic and political union between member countries.

The ECB plays a role similar to that of the US Federal Reserve or the Bank of Japan. It serves as the official issuer of the euro. It sets interest rates, a key factor in guiding the economy, and it plays an important role supervising commercial banks.

The ECB’s first job, according to the treaty, is to keep inflation under control. That is different from other central banks such as the Federal Reserve, which has a broader mandate to seek both low inflation and high employment. The ECB is also tasked with supporting the economic goals of the EU, including growth and jobs. But stable prices come first.

Q: How does the ECB affect the economy?

A: The ECB’s main way of affecting the economy is through its benchmark interest rate, the refinancing rate, which determines what banks pay when they borrow money from the ECB. That in turn influences the rates banks charge for loans to customers such as businesses and consumers.

So the ECB can cut rates to spur economic activity when the economy looks weak. And it can raise interest rates to restrict credit when the economy is growing strongly. That helps prevent inflation.

The ECB can also use other, more unusual means to affect the economy. Those can include issuing loans to banks or purchasing bonds from banks to boost their finances.

(FRANCE 24 with AP)
 

The ECB lowered the deposit rate to -0.1%, meaning it will effectively charge banks for holding their money overnight. It cut its main refinancing rate to 0.15%, and the marginal lending rate  or emergency borrowing rate  to 0.40%.

Markets sent the euro to a four-month low of $1.3575 after the news.

The ECB promised to disclose further monetary policy measures in another press release later this afternoon. (replaced: “Further monetary policy measures to enhance the functioning of the monetary policy transmission mechanism will be communicated in a press release to be published at 3.30 p.m. CET today,” the ECB said in a statement.)

Draghi’s press conference

Reuters reported last month that the ECB was preparing a package of policy options for this week’s meeting, including the rate cuts and targeted measures with a view to boosting lending to small- and mid-sized firms (SMEs).

Economists polled by Reuters had expected the ECB to cut the refinancing rate to 0.10% from 0.25 % and the deposit rate to -0.10% from zero, as well as launching a refinancing operation aimed at funding firms.

“This is a baby rate cut - a tweak to the policy stance,” said RBS economist Richard Barwell, adding that ECB President Mario Draghi needed to announce a bundle of measures to avoid disappointing markets.

“I think expectations are very high,” Barwell added. “To exceed them, I think he (Draghi) is going to have to talk up the prospect of asset purchases in the near future.”

Background

In an April 24 speech, Draghi set out three broad scenarios for ECB policy action and included the possibility of a broad-based asset-purchase programme in the event of a worsening of the medium-term inflation outlook.

Such a programme is unlikely for now, however, even though eurozone annual inflation unexpectedly slowed to 0.5 percent last month, figures published earlier this week showed. The ECB targets inflation of close to but below 2 percent.

Draghi will present updated inflation and growth projections from ECB staff at his news conference. In March, the forecasts showed it would take 2-1/2 years for inflation to get near the ECB’s target. A weaker outlook will support robust ECB action.

QE on the shelf

The ECB is widely expected to accompany the rate cuts with other measures such as offering banks cheap, long-term funding - a so-called LTRO - on condition that they use this financing to further lending to companies.

Eurozone inflation has been stuck in what Draghi has called “the danger zone” below 1 percent since October, mainly because of weaker commodity and food prices, but also because of wage and other adjustments in eurozone crisis countries.

The stronger euro exchange rate exacerbates these dynamics.

At the same time, record low interest rates are still not feeding through evenly to companies across the currency bloc. Companies in Portugal, for example, are paying on average 5.4 percent on loans compared with 2.2 percent in Finland or France.

This particularly affects smaller companies, which rely strongly on bank funding and make up the bulk of the economy.

Another possibility is the for ECB to extend its provision of unlimited access to central bank funding beyond July 2015.

U.S.-style quantitative easing (QE) - money printing to buy assets - is likely to remain someway off, however, as it is the last weapon at the ECB’s disposal and the barriers to using it are high for the hawkish contingent on the Governing Council.

“We expect the big QE-bazooka to remain in the closet,” said ING economist Carsten Brzeski.

(FRANCE 24 with REUTERS)

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