Central bank moves to kickstart Europe

By David McHugh

The eurozone countries have struggled to get out of the global financial crisis, and the ECB has moved to prevent a slump into deflation. Photo / AP
The eurozone countries have struggled to get out of the global financial crisis, and the ECB has moved to prevent a slump into deflation. Photo / AP

The European Central Bank has ventured into uncharted territory with a raft of unusual measures meant to revive the eurozone economy by getting credit flowing to companies and preventing a debilitating bout of deflation.

The ECB was spurred into action by evidence that growth in the 18-country eurozone is too weak to keep consumer price inflation at a healthy level. The fear is the low inflation will last or, worse still, become an outright drop in prices that, if sustained, can snuff out what little growth Europe has.

Expectations were high for the central bank to show it would finally act to prevent such a scenario after months of hesitation in which the inflation rate kept falling. The last measure, for May, showed inflation was only 0.5 per cent, far below the bank's goal of 2 per cent.

The ECB's 24-member governing council finally struck yesterday, releasing a package of measures including interest rate cuts which lowered one rate into negative territory for the first time. It also promised billions in cheap loans for banks on condition they lend more and announced a programme to use financial markets to round up more cash for companies.

Here's a brief look at what the ECB did and why.

The eurozone countries have struggled to get out of the global financial crisis, and the ECB has moved to prevent a slump into deflation. Picture / AP
The eurozone countries have struggled to get out of the global financial crisis, and the ECB has moved to prevent a slump into deflation. Picture / AP

What's the ECB worried about? Why all the drama?

Low inflation, and the danger that it becomes a habit. People might start postponing purchases because they think the prices of goods will fall. That's deflation, a trap that is hard to get out of. Japan is still struggling to get out of a deflationary trap that started in the 1990s. Mario Draghi, the ECB's president, says the eurozone is "strongly determined" to keep that from happening.

What is the ECB trying to do?

The ECB is aiming to get banks to lend more money at affordable rates, especially to companies in those countries, such as Spain and Portugal, which were hit hardest by the recent economic and financial crisis. Without those loans, companies can't invest and create jobs and consumers can't borrow to buy homes and other goods.

So what did the ECB do yesterday in order to achieve that?

First, it cut its benchmark interest rate, the rate at which it lends to banks. In theory, banks pass that rate on to companies and consumers by making their loans cheaper. The rate was already at a record low of 0.25 per cent, and lowering it to 0.15 per cent will only help a little bit.

So the bank did more. It cut its deposit rate to minus 0.1 per cent - a very unusual and untried step. In effect, banks will pay a penalty - negative interest - if they leave money at the ECB. It's an incentive for them to lend it out instead. No one's sure it will work. It was tried in Sweden and Denmark but has not been used in an economy as big as the eurozone.

Is that all?

The ECB will also offer targeted, ultra-cheap loans to banks on condition they lend to businesses. That means the more the banks lend, the more cheap cash they can scoop up from the ECB. The banks would have a secure source of cheap cash to do business with - on the condition that they risk some of that money as loans. The size of the program was not determined yesterday, but it is likely to be significant - some 400 million.

That's it?

There's more. The ECB will stop taking weekly deposits from banks in connection with an earlier stimulus programme of bond purchases. It's a bit technical, but the bottom line is that it will leave an extra 175 billion ($281 billion) in the financial system. It's also going to do "preparatory work" on buying packages of bank loans to small business in the form of bonds. The idea is to encourage banks and financial institutions to create such bonds - for which, of course, they need to make loans.

Did the ECB do enough? Will it raise inflation?

Markets greeted the measures with a burst of euphoria - Germany's DAX blue chip index broke 10,000 for the first time in its history. But the immediate market impact faded quickly. Some investors want more details on these programmes to understand how effective they'll be.

Many economists also note the ECB didn't do what would have been most effective - buy large amounts of financial assets such as bonds to pump newly created money into the financial system. It's called quantitative easing. Other central banks like the US Federal Reserve have done that, but it's more complex in a currency union with 18 members.

Draghi appeared to leave such action as a possibility, saying "if need be, within our mandate, we aren't finished here".

Analyst Richard Barwell at Royal Bank of Scotland said comments like that mean "expectations of a broad-based asset purchase programme will rapidly start to build".

- AP

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