ECB cuts interest rates to record low

The growing threat of economic stagnation has pushed European Central Bank into surprise action

by Dave Waller
Last Updated: 05 Mar 2015

The European Central Bank has cut interest rates to a record low and announced a new credit scheme to pump money into the eurozone banking sector, in a bid to stimulate inflation. Clearly it too had grown tired of waiting for the Eurozone's beleaguered economy to show any sign of springing to life itself – and thought better of the Basil Fawlty approach of simply whacking it loads with a big branch.

In late August, ECB president Mario Draghi acknowledged himself that markets had begun to doubt the bank's ability to get things back on target, so some action was inevitable. But many have been surprised by the extent, with Draghi announcing a raft of plans that would have a 'sizeable impact on our balance sheet'.

First the ECB cut its benchmark main refinancing rate from 0.15% to 0.05% and said it would charge lenders 0.2%, up from 0.1%, for parking deposits there. It also launched an asset-backed securities programme to fight deflation, which will start from October. This could involve the ECB committing hundreds of billions of euros to buy up bundles of financial assets, such as loans to companies and mortgages, from banks and other investors.

The idea behind all this is that banks will be more willing to make loans to the real economy if they can then package the debt into new securities and sell them to the ECB. Of course that's a potentially risky move from the ECB. The euro fell below the key threshold of $1.3 to hit a low of $1.2995 following the news – it's now down almost 5% against the dollar since the beginning of July – but could weaken further if European banks then decide to use the cash they've got to purchase assets abroad via euro-funded carry trades.

European government bond yields didn't fare much better at the news. The yield on Italian 10-year bonds fell by 11 basis points to 2.36%, while Spanish 10-year bonds dropped 11 bps to 2.16%. But the markets were buoyant: the FTSE 100, for example, rose 0.3% on its already strong performance yesterday.

Draghi's not biting on calls to set up a programme of government bond purchases – a decision isn't expected on that till the end of the year – but he intimated that full-scale quantitative easing is still very much a possibility, citing a 'unanimous commitment to using additional unconventional instruments' should low inflation persist for too long. Bear in mind that, sat at 0.3%, it's currently at a five-year low, while the region's economy failed to grow at all in the second quarter.

Draghi also backed greater centralisation of economic policy making and plans for a €300 billion public-private investment programme.

The ECB has now revised its forecasts, predicting annual HICP inflation to be at 0.6% in 2014, 1.1% in 2015 and 1.4% in 2016. That's a revision downwards since June for the 2014 figure while the others are unchanged. As for growth, it now expects the eurozone economy to grow by 0.9% in 2014, 1.6% in 2015 and 1.9% in 2016. The projections for 2014 and 2015 have been revised downwards and the projection for 2016 has been revised upwards.

As to whether it pans out like that, is anyone's guess. But one thing is more certain. While Draghi asserts that a 'comfortable majority' voted for today’s decisions, the lack of unanimity suggests it didn't exactly come about as the natural result of a pleasant chat over a load of pains au chocolat. In fact you'd hope they'd have deflated to plain croissants by now anyway. 

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