LONDON (TIP): The European Central Bank (ECB) on Thursday cut interest rates and took a raft of unconventional steps to prevent the 18-country eurozone from sliding into a bout of deflation that could kill off a muted economic recovery.
The ECB’s steps aimed to raise inflation and increase the flow of credit in an economy where lending is weak. They include cheap, long term loans to banks, tied to the understanding banks would loan the money to businesses, boosting growth. And for the first time ever, it took the untested step of imposing a negative interest rate on money that banks deposit with it, from zero to minus 0.1 per cent. That would push the banks to lend the money, not hoard it.
It also cut its main interest rate, the refinancing rate, from 0.25 per cent to 0.15 per cent. The actions contributed to a rally in European stock markets and a further fall in the value of the euro. Announcing the new measures, ECB President Mario Draghi told a press conference that the central bank would: offer long-term loans to banks at cheap rates until 2018.
The targeted loans would be charged a fixed rate, meaning that the rate could not rise, even if the ECB raises its benchmark. That gives banks confidence they have cheap funding out through 2018. The amounts they can borrow will be tied to the amounts banks lend to companies. Start doing “preparatory work” on a program to buy batches of loans to small businesses in the form of bonds, a step to funnel more credit to companies through financial markets.
Stop collecting weekly deposits aimed at offsetting the monetary effects of earlier bond purchases. That would leave an additional 175 billion euros in the financial system that banks could in theory use to lend to each other or to companies. Draghi also did not close the door to a still more drastic step, large-scale purchases of bonds to inject newly created money into the economy.
Many economists say that would be the most effective step the bank could take in boosting inflation. The U.S. Federal Reserve, Bank of Japan and Bank of England have all made such purchases. But the ECB has held off due to the legal and practice complexities of such purchases in a currency union with 18 different members. Draghi said ECB policymakers were in agreement about pursuing further unconventional measures to boost inflation if it stays too low.
That’s important because it indicates that Germany’s influential Bundesbank, often skeptical of stimulus measures, is on board. Bundesbank head Jens Weidmann has only one vote, but outsized influence because of Germany’s role as the eurozone’s biggest economy. “In pursuing our price stability mandate, today we decided on a combination of measures to provide additional monetary policy accommodation and to support lending to the real economy,” he said. At last count measure, inflation was 0.5 per cent, far below the ECB target of 2 per cent.
Mr. Draghi said inflation this year would be 0.7 per cent, down from the previous forecast of 1 per cent. However, he said inflation in 2015 would rise to 1.1 per cent and 1.4 per cent in 2016. Weak inflation has raised fears the eurozone may slide into outright deflation, a sustained drop in prices that can choke off growth as consumers and companies delay spending in hopes of bargains.
The eurozone economy grew only 0.2 per cent in the first quarter, and unemployment remains high at 11.7 per cent. The new approach caused big movements in the markets. Stocks rose, with Germany’s DAX index trading above 10,000 for the first time. The euro fell to $1.3555 from about $1.3600. Looser monetary policy tends to weaken a currency. “I think it’s safe to say the markets fully approved of the measures announced by Mr. Draghi,” said Craig Erlam, market analyst at Alpari. “Moreover, I don’t think the sell-off is over yet,” he added, saying the euro is likely to touch $1.34 over the next week.