European Central Bank Moves to Negative Interest Rates

The European Central Bank (ECB) cut its deposit rate below zero and said that further measures were imminent as its policy makers respond to the prospect of deflation in the world’s second-largest economy.

The ECB also announced a €400bn package of cheap funding for banks, with the proviso that it is used to lend money to companies outside the financial sector and not for mortgages.

ECB president Mario Draghi reduced the deposit rate to negative 0.10% from zero, making the institution the world’s first major central bank to use a negative rate. Policy makers also lowered the benchmark rate to 0.15% from 0.25%, ahead of a press conference to be held by Draghi in Frankfurt.

He has said a worsening in the medium-term outlook for prices would justify broad-based asset purchases, and with inflation consistently below the ECB’s goal for the past eight months, that scenario remains possible. A lower-than-expected figure for May eurozone inflation, which at a rate of 0.5% per year was well below the central bank’s target of just under 2%, had cemented expectations

The ECB stopped short of pumping funds directly into the financial system via a programme of quantitative easing (QE), but Draghi said the bank would “intensify preparatory work” if necessary, and left the door open to further stimulus if needed.

“We think this is a significant package,” he added. “Are we finished here? The answer is no. If required, we will act swiftly with further monetary policy easing. The governing council is unanimous in its commitment to using also unconventional instruments within its mandate should it become necessary to further address risks of too prolonged a period of low inflation.”

Unchartered territory

The move into negative interest rate territory is a first as neither the US Federal Reserve, Bank of Japan (BoJ) nor Bank of England (BoE) have ever attempted it. The ECB hopes the move will lift inflation by weakening the euro and spurring lending in the bloc’s more troubled periphery.

Borrowing costs across countries worst affected by the eurozone’s debt crisis dipped only slightly following the ECB’s decision to cut rates. The yield on Spain’s benchmark 10 year bonds, which rose above 6.8% at the height of the eurozone debt crisis, edged down from 2.87% to 2.86% after the reduction was announced.

Commenting on the ECB’s move, Tom Elliott, international investment strategist for deVere Group said: “This addresses head-on a key problem in the region’s economy, which is banks’ preference to hoard cash in order to help repair their balance sheets.

“The bold action … means that the region’s banks will now have to pay the ECB to hold their cash. It is intended to force banks to lend out their cash instead, so boosting economic recovery.”

“There was no eurozone version of the Troubled Asset Relief Programme [TARP] in the US that allowed banks to write-off bad loans and start afresh after the credit crunch. Instead the bad loans became nationalised, through state bailouts of banks, or left to fester on banks’ balance sheets, creating a region of weak banks. It is this policy failure that is at the heart of weak growth and rightful anxieties over the threat of deflation.

“These measures confirm that the ECB is finally facing up to the cold reality of Europe’s weak banks. European stock markets have rallied, the euro has weakened and the markets appear satisfied – for now – that the ECB will act to prevent further falls in consumer prices.”

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