ECB makes surprise rate cut to avert deflation

Simon Morgan

The European Central Bank surprised financial markets on Thursday with a new cut in key interest rates and other measures to ward off deflation in the single currency area.

The announcement sent the euro down to the lowest level against the dollar for 13 months, and boosted European and US stocks.

Against a background of growing concern that the eurozone is on the verge of a dangerous spiral of falling prices, the ECB cut its central "refi" refinancing rate to 0.05 percent from 0.15 percent.

It also lowered the deposit rate to minus 0.20 percent and trimmed its marginal lending rate to 0.30 percent.

In addition, at a news conference afterwards, ECB chief Mario Draghi unveiled plans to buy asset-backed securities (ABS) to help kick-start credit in the region, as well as a programme to purchase covered bonds.

Both of these schemes would start in October, with details to be announced after the ECB's October meeting, Draghi said.

But the central bank's anti-deflation tools need not stop there.

"Should it become necessary to further address risks of too prolonged a period of low inflation, the governing council is unanimous in its commitment to using additional unconventional instruments within its mandate," Draghi vowed in what markets took as a hint at what is known as "quantitative easing."

- QE discussed -

Draghi said a "QE" programme -- a radical policy used by other central banks such as the US Federal Reserve and Bank of England of buying securities on a big scale to inject cash into the economy -- had been discussed.

But for the time being the governing council had opted for a narrower ABS scheme instead.

Asset-backed securities are bundles of individual loans such as mortgages, auto credit and credit-card debt that are sold on to investors, allowing banks to share the risk of default and encouraging them to offer more credit.

Draghi revealed that the decisions were "not unanimous."

"Some governors were in favour of doing more, some were in favour of doing less," he said.

Nevertheless, the measures adopted were agreed by a "comfortable majority" on the decision-making governing council, Draghi said.

The need to act became necessary as the growth and inflation outlook continues to cloud over.

According to the ECB's own latest forecasts, gross domestic product (GDP) is expected to expand by 0.9 percent in 2014 and 1.6 percent in 2015, lower than previous projections.

The bank said inflation was expected to come in at just 0.6 percent this year, way off the ECB's target of 2.0 percent.

Inflation cannot be brought back up to target by means of monetary policy alone, and governments must also play their part with reforms, Draghi insisted.

- No game-changer -

Analysts welcomed the latest barrage of measures, even though they were sceptical about how effective they would be.

"There are big questions over the effectiveness of the further reduction in interest rates and, while the asset purchases may have a more significant impact, little is known about just how much many assets the ECB will be able to buy and what impact this will have on the economy," said Chris Williamson at Markit (NasdaqGS: MRKT - news) .

"Perhaps the main immediate benefit of the additional policy action is a weakening of the exchange rate. The lower exchange rate will undoubtedly provide a boost to exporters' competitiveness," Williamson said.

"Today's ECB moves are a step in the right direction, but too little, too late to snuff out deflation-risk and kick-start growth," said Hermes Group chief economist Neil Williams.

The cuts in interest rates were "puny, and look more cosmetic than real. Any drop in the euro on the back of them would be welcome, but possibly short lived," he warned.

"Whether all of this will help remains to be seen," concurred ING DiBa economist Carsten Brzeski.

"Today's measures will not be the big game changer or kick-starter for the eurozone economy but at least in the short run the resulting weaker euro exchange rate and financial markets' buoyance should bring some relief," he said.

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