ECB steps up battle against low inflation, slow-moving economy

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The European Central Bank entered untested territory by dropping a key interest rate into negative territory as it ramped up its campaign to prevent deflation and push down the euro. But the move, unprecedented for a big central bank, fell short of the all-out assault that the sluggish European economy may need to restore strong growth.

The negative rate was part of a deflation-fighting and growth package that included a plan to offer €400-billion ($597-billion) in cheap loans to the banks in the hope they will use the fresh liquidity to boost loans to businesses. ECB president Mario Draghi said he's ready to deploy more weapons if inflation remains dangerously low, including quantitative easing – printing money, effectively.

"Are we finished? The answer is no," he said Thursday, after the ECB's regular policy-setting meeting in Frankfurt.

The equity markets rose after the announcement and the euro fell, only to reverse course later in the day to finish up a quarter of a percentage point, to $1.36 (U.S.). Some economists said the euro's defiant rise was evidence that low inflation trend will be hard to break even if the ECB insists it sees no risk of outright deflation.

In a note, the European think tank Bruegel said the ECB package seemed more of an attempt to juice up bank lending than end disinflation. "We expect the package to have a positive effect. However, it will take quite some time until inflation dynamics will come back to where they should be and further measures will likely be needed," Bruegel said.

The ECB cut the main refinancing rate to 0.15 per cent from 0.25 per cent. The deposit rate, which was already at zero, was cut by the same amount, pushing it to minus 0.10 per cent. The deposit rate is the interest paid to any bank which parks its money at the ECB overnight. The negative rate – essentially a fee charged on the deposits – is designed to encourage the banks to lend out the money and put some downward pressure on the euro, whose rise had helped to drag down the inflation rate "Now we are in a completely different world," Mr. Draghi said, citing "low inflation, a weak recovery and weak monetary and credit dynamics."

The ECB's big new program to stimulate the real economy came through the new cheap loans to banks, known as LRTROs – targeted longer-term refinancing operations – which was designed to reduce the banks' funding costs.

The bank liquidity program will allow banks to borrow money from the ECB to an amount worth 7 per cent of their outstanding loans to non-financial corporations and households, excluding mortgages. The maturity will be up to four years, at a rate set at the ECB's benchmark rate plus a mere 0.1 per cent. Banks that hoard the money instead of lending it out will be forced to repay it after two years.

While the ECB stopped short of putting quantitative easing into action, Mr. Draghi announced that the bank had started to work for the "outright" purchases of assets to help smooth lending and juice up the economy. While no details were released, the plan would probably see the ECB buy asset-backed securities and corporate or sovereign bonds.

Bruegel, the think tank, said the problem with the potential purchase of asset-backed securities is that they make up only a small market in Europe. "So in fact if the ECB was to decide to buy, it would very quickly buy up the entire current market," it said.

Even though quantitative easing was left out of the package, economist said it was the ECB's boldest move since mid-2012, when Mr. Draghi promised to do "whatever it takes" to keep the euro zone intact. At the time, the crisis was near its peak and speculation was rife that Greece was about to leave the euro zone.

Since then, the ECB has taken little stimulatory action even though growth rates have been weak and inflation has been falling since 2011, turning negative in some countries. Last November, the ECB cut rates by a quarter point and Mr. Draghi tried to "talk down" the euro by hinting that deflation-fighting measures were imminent.

When inflation fell to 0.5 per cent in May, down from 0.7 per cent in April, the ECB was forced to act. The ECB's target inflation rate is close to 2 per cent. Very low inflation or deflation – falling rates – provides an incentive for businesses and consumers to delay purchases, damaging the economy.

If inflation doesn't pick up, and growth remains weak, it seems almost certain that the ECB will embark on quantitative easing. "Today's measures are not yet a whatever-it-needs moment for the Eurozone economy but they are at least a good package which will give the Eurozone some additional monetary tailwind," said ING Financial Markets economist Carsten Brzeski.