ECB cuts key rate to 0.25%. Here’s what that says about the eurozone.

Surprise, even shock. That was how investors and the media greeted European Central Bank (ECB) President Mario Draghi’s move to cut the benchmark rate to 0.25% on Thursday. Most observers had expected the ECB to stay pat at least until next month before making any move on interest rates. But October’s worrying inflation rate – 0.7%, a four-year low – clearly spurred the bank into swift action.

Truth be told, it’s difficult to see how a 25 basis point cut in the ‘refi’ rate will stimulate demand and prices. (100 basis points equal one percentage point.) Rates were already at a historic low before of 0.5%; the new rate cut has created a fresh low for interest rates in the 17-nation currency union. Low rates, in theory, are supposed to stimulate lending, consumption and investments. Yet lending has barely budged, as the ECB statement notes. Most banks have been unwilling to lend against an uncertain economic outlook (for fear of being saddled with more bad loans) .

The markets were pleasantly surprised, but let’s face it, interest rates are now becoming an increasingly blunt instrument for the ECB. Nevertheless, the surprise cut indicates the bank wants to be seen as prepared to take action to head off the threat of deflation.

The statement released by the ECB suggests three things about central bank thinking:

One, the ECB takes the threat of deflation seriously, even if it doesn’t publicly admit that – and decided it was best to act sooner than later.

Deflation is an economic phenomenon in which prices fall continuously. That might seem a good thing for consumers, but actually it can be quite harmful for economic growth. When prices exhibit a falling trend, consumers tend to reduce consumption on the expectation that goods will be cheaper in the future. Businesses then report declining profits, which forces them to slash wages, re-inforcing, in turn, the reduced appetite for spending.

More importantly, once deflation takes hold, it is extremely difficult to reverse. Look no further than Japan for proof. Clearly, Draghi is intent that Europe does not turn into Japan under his watch. When asked by a reporter on how significant the threat of deflation was,cut the rate, the ECB President, however, downplayed the phenomenon: “If by deflation we mean a self-fulfilling fall in prices across a very large category of goods and across a very significant number of countries, we do not see that happening,” he said.

So the man says. But if the threat of deflation were not a ‘clear and present danger’, there would have been no need to cut rates now – or promise to do more if required. On its own, a weak eurozone may not be able to withstand the pressure of falling prices. So the central bank had to act.

Two, prices are expected to stay low for a long time in the eurozone. Monetary policy, as a result, will continue to be ultra-loose.

That much Draghi admits. “… we may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on,” the statement says. Translation: Any pick-up in economic activity will be so gradual that higher prices will not strike euroland for a long, long time.

Indeed, the eurozone has only limped back to growth, experiencing 0.3% growth in the second quarter of this year, after six straight quarter of falling output. To support the fragile on-going recovery, the ECB has promised to keep interest rates low for as long as required, hinting that more cuts could also be on the way: “Following today’s rate cut, the Governing Council reviewed the forward guidance provided in July and confirmed that it continues to expect the key ECB interest rates to remain at present or lower levels for an extended period of time,” the statement notes.

So unlike the U.S. Federal Reserve, which is now actively considering when it will start withdrawing its on-going massive monetary stimulus, Europe’s top monetary authority is expected to keep policy super-easy in the medium term. “… our monetary policy stance will remain accommodative for as long as necessary,” the statement says.

Three, more policy action, perhaps unconventional as well, will be forthcoming from the ECB if inflation doesn’t behave nice.

Draghi indicates that interest rates are not the only weapon in his arsenal. More Quantitative Easing measures (typically engineered through the central bank buying assets and releasing funds into the economy) are also on the table. They are likely to be used soon.

In a nutshell, Europe continues to struggle as it slowly recovers from the credit and sovereign debt crises of the recent past. But despite the looming threat of deflation, the ECB is not giving up the fight for growth just yet.

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One thought on “ECB cuts key rate to 0.25%. Here’s what that says about the eurozone.

  1. Pingback: Here’s why Fed tapering might not be as scary as it seems | Wall of Money

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