After 10 months on hold, the European Central Bank (ECB) cut its main policy interest (refinancing) rate from 0.75% to 0.50% last week, as macroeconomic data continued to worsen in the Eurozone.
Analysts believe that leading indicators of economic activity over the past two months suggest that the recession in the Eurozone could deepen over the second and third quarters of this year.
Schroders’ European economist, Azad Zangana, said: “While the recovery is being called into question, underlying inflation is falling across the Eurozone. Annual headline HICP inflation rate has fallen from 2.2% at the end of 2012 to 1.2% in March – meeting the European Central Bank’s target of below, but close to 2% annual inflation, but also becoming a little too low for comfort. The falls have been largely as a result of lower inflation from energy and transportation costs. However, with the economy in recession and unemployment rising sharply in a number of states, rising spare capacity especially in the labour market is causing a build-up of deflationary pressure.
“In our view, the cut in the main policy interest rate will not have a significant impact on the economy. Those banks that are able to access funding from financing markets (and therefore able to lend) were already enjoying much lower interest rates thanks to the huge amount of liquidity the ECB has pumped into the system. The banks that are reliant on the ECB for funding will benefit from the reduction in their funding cost, but are unlikely to be in a position to increase lending, and so will not pass on the rate cut to households and businesses.
“In addition to the cut in the main policy rate, the ECB also reduced the marginal lending rate, which is paid by banks that borrow more than the prescribed usual amounts, from 1.50% to 1%. The ECB also extended the generous “full allotment” mode of banks financing until at least July 2014. ECB President Mario Draghi stated that the bank was exploring options of using the central bank’s balance sheet to support additional lending for small and medium sized enterprises. This would be done through the restarting of the asset backed securities market (ABS) in Europe, which would allow the ECB to buy and hold securitised debt, and hopefully lower the cost of funding for corporates.
“In addition to the interest rate cut, the most significant comment made today was the hint that the main policy rate could yet be reduced further, but also that the deposit rate could be cut from zero into negative territory. This would follow the actions of the Swiss National Bank and the Danish central bank (Nationalbanken), which essentially charges banks to hold deposits, therefore encouraging them to use their deposits in a more productive way for the economy.
“The reaction in financial markets has been mixed. The Euro has fallen by approximately 0.9% against the US dollar, while European equity markets are mixed. However, the news has been positive for short-dated T-bills, and even 2-year German government bonds (Schatz), where the yield to redemption has now fallen into negative territory.
“Overall, the cut in ECB interest rates today is marginally helpful, but is unlikely to solve any of Europe’s fundamental problems, which are bearing down on the economy. The hint that the ECB would consider a negative deposit rate is useful in prompting banks to re-allocate their capital to more productive areas of the economy, however, there is a risk that the move could encourage banks to charge depositors, and for those depositors to withdraw their cash, and opt for hiding their savings under their figurative mattresses.”
He added: “Finally, the potential purchases of loan backed securities would be positive for stimulating lending to the real economy. However, we are unlikely to see purchases begin before the autumn as the need for the ECB to coordinate with the European Commission will take time.”
