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ECB cuts rates to aid flagging euro zone economy

Reuters
Jul 05, 2012 at 06:24pm IST

Frankfurt: The European Central Bank cut interest rates to a record low on Thursday to breathe life into a deteriorating euro zone economy and back up measures agreed by government leaders last week to tackle the bloc's debt crisis.

The quarter-point cut in the ECB's main refinancing rate to 0.75 per cent was in line with market expectations and followed a dire batch of economic data that show even euro zone powerhouse Germany is entering a modest downturn.

European shares extended gains on the news and the euro fell. Of 71 economists polled by Reuters, 48 had expected the bank to cut, most of them by 25 basis points, though some others forecast a larger decrease.

ECB cuts rates to aid flagging euro zone economy

The quarter-point cut in the ECB's main refinancing rate to 0.75 per cent was in line with market expectations.

"This outcome is probably the one that is most acceptable to the ECB at this stage," said Nomura economist Jens Sondergaard, who had forecast a cut to 0.50 per cent in the main rate.

"I think the big question is 'is that a unanimous rate decision', or are there dissenting members that would have preferred no change?"

ECB President Mario Draghi will explain the Governing Council's decision at a 1230 GMT news conference.

The ECB's loosening of policy followed shortly after China and Britain did similar.

In addition to cutting the main refinancing rate, the ECB also reduced its deposit rate, which acts as a floor for the money market, to zero from 0.25 per cent.

This move could encourage banks to lend to each other rather than simply parking funds of up to 800 billion euros back at the ECB every night.

The interest rate cut is not seen as a panacea for the euro zone's problems, which stem from a loss of confidence in state and bank finances, but the reduction in borrowing costs shows the ECB is ready to support the flagging economy.

IMF pressure

The central bank had faced pressure from investors and even the International Monetary Fund to take bolder measures, with IMF Managing Director Christine Lagarde urging the bank to resume its purchases of government bonds.

ECB policymakers are unlikely to heed this advice, as a core of them feel the bank's bond buying programme - dormant for four months now - amounts to monetary financing of governments, which is beyond the bank's mandate.

While the ECB is not ready to announce that the SMP bond programme is officially over, it has become clear that the purchases would be restarted only in an absolute emergency.

"The bond buying programme is in a deep sleep, and it will remain there," ECB Governing Council member Klaas Knot said in a magazine interview released on Wednesday.

By contrast, easing price pressures gave the ECB plenty of cover to cut rates, backing up the summit deal last week when government leaders agreed to let the euro zone's rescue fund inject aid directly into banks and intervene on bond markets.

While inflation remains above the ECB's target of just below 2 per cent, it has been sliding recently and ECB staff expect it to average 1.6 per cent next year, giving room for a rate cut.

Business surveys released on Wednesday strengthened the case for a cut, showing the euro zone's private sector downturn eased only slightly in June and that it remains in recessionary territory.

The cut will be welcomed by the southern European banks that have tapped the ECB heavily for loans. The 25-basis-point cut will decrease annual interest payments from the 1 trillion euros in 3-year loans by about 2.5 billion euros.

Investors will now focus on Draghi's news conference for news of any other action the ECB may take.

There is a slim chance the ECB will offer a repeat of the twin 3-year ultra-cheap loans with which it funnelled over 1 trillion euros to banks in December and February.

However, the ECB is unlikely to announce any further "non-standard measures" - bond purchases or ultra-long loans - after already loosening its lending rules on June 22. It will want to see the impact of that step before tweaking the framework.

Draghi will be quizzed on how firm the central bank's opposition is to reactivating its bond buy programme, and whether it could change its mind regarding giving the ESM bailout fund the option to tap ECB funds.

Less clear is what Draghi will say about giving the euro zone's ESM permanent bailout fund a banking licence, which would allow it to exponentially increase its firepower from the planned 500 billion euros.

Some analysts see the ECB changing its course on ESM as the best option to quell the debt crisis.

"I think it's easier for the ECB and the Bundesbank to change their minds regarding the ESM than to reactivate the SMP programme," said Natixis economist Sylvain Broyer.

"We will at some point have to buy sovereign debt en masse, and it would be cleverer to let the ESM do it."

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