European Institute

By James D. Spellman, Principal, Strategic Communications, LLC

Telegraphing for months the likelihood of an unprecedented “pre-emptive” strike against deflation, the European Central Bank president today (June 5) finally announced one unorthodox step: widely anticipated “negative” interest rates to weaken the Euro. He also introduced targeted measures to boost cheap credit for small and medium-sized businesses, the EU’s locomotives for growth, pledging interest rates will remain low "possibly for longer than previously seen."

Against mounting data showing Europe’s economy still beleaguered by low inflation^[1], high unemployment, and anemic consumer confidence, the ECB lowered both the main lending rate from 0.25% to 0.15% and, potentially even more consequential, the nominal deposit rate paid to banks on overnight deposits, currently zero, to minus 0.1% (in effect, a fee on banks for funds deposited with the central bank). About €33.23 billon is parked at the ECB overnight, down sharply from the 2012 peak when banks put a record €827 billion overnight.

Source: Trading Economics. http://www.tradingeconomics.com/euro-area/inflation-cpi

"Now we are in a completely different world," said ECB President Mario Draghi in making the announcement at a news conference in Frankfurt. "Today we decided on a combination of measures to provide additional monetary policy accommodation and to support lending to the real economy. The governing council is unanimous in its commitment to using unconventional instruments within its mandate should it become necessary to further address risks of too prolonged a period of low inflation.”

He had set expectations high on May 8, when he said officials would be "comfortable" acting in June, that deflation "would be the context for a broad-based asset purchase program."

Draghi argues that negative deposit rates may weaken the Euro while encouraging Eurozone banks to lend more to one another, especially to those in the peripheral economies. He expressed confidence that the rate cut will devaluate the Euro to a reasonable level without undermining financial stability. Immediately after his announcement the Euro fell, European stocks surged to a 6½-year high, and U.S. stocks reached new records.

Most Eurozone banks have assured their central banks that they are operationally ready.^[2]

To close the credit gap between the amount of lending now available and what normally should be provided, the ECB also announced targeted measures to boost cheap credit, including offering long-term loans at reduced rates until 2018, and doing "preparatory work" to begin buying batches of loans for small businesses. The long-term refinancing operation (LTRO) had been used to plow €1 trillion into banks during the global financial crisis (2011 and 2012), largely to pay off maturing debts and promote lending to strained governments and customers.^[3] ECB’s rate for the new funds will depend on banks’ commitment to create credit.

Source: European Central Bank. Available at: http://www.ecb.europa.eu/stats/pdf/blssurvey_201404.pdf?c306571c8c7c155979c17b29c89c69b8 .

With SMEs accounting for two out of every three jobs and 58 percent of gross value in the EU, more accessible and affordable credit could help lower unemployment.^[4] Draghi has attributed as much as one-third of Europe’s economic sluggishness to SMEs not getting the financing they need at the rates they can afford to pay, particularly in the southern periphery, a “pernicious negative spiral,” as he put it.^[5] (Banks, however, complain about low demand and the lack of creditworthy borrowers.) The ECB’s April survey showed the availability of bank loans continues to be a problem, albeit less so.^[6]

The logic behind today’s move is seen in the ECB’s own study of “non-standard” policies by the Federal Reserve and ECB during the financial crisis. Earlier on, such approaches lowered bank funding volatility and increased loan supply, the study found.^[7] “We find strong evidence that the bank-based non-standard measures adopted by Fed and ECB eased conditions in money markets and that those easier conditions resulted in an increase in business lending by banks.”

Pressure had been building on Draghi to do something. The OECD recently urged the ECB “to take new policy actions to move inflation more decisively towards target and to be ready for additional non-conventional stimulus if inflation were to show no clear sign of returning there." The IMF made similar demands as the two-percent target for inflation proved too elusive for the ECB. And, since May, the financial markets have been pricing into equity and bond pricing ECB actions as if they were a fait accompli. Had the ECB not acted, a sharp selloff would likely have happened.

Draghi used the announcement to emphasize the role that banks and governments must also play. "In order to strengthen the economic recovery, banks and policy-makers in the euro area must step up their efforts,” he said. “Banks should take full advantage of this exercise to improve their capital and solvency position, thereby contributing to overcome any existing credit supply restriction that could hamper the recovery. At the same time, policy-makers in the euro area should push ahead in the areas of fiscal policies and structural reforms.”