FRANKFURT: The European Central Bank is widely expected on Thursday to cut its key interest rates and unveil other unconventional measures in a battle against deflation, analysts said.
After effectively pre-announcing a move last month and carefully priming the financial markets for action since then, the ECB’s governing council is finally expected to deliver at its regular monthly policy meeting on Thursday.
A slew of recent economic data—including disappointing growth and slowing inflation—has hardened the case for decisive measures.
Indeed, ECB watchers believe the central bank’s credibility will be on the line if it fails to follow up all of its recent rhetoric with concrete moves.
The ECB has held its key interest rates steady at their current all-time lows—of 0.75 percent, 0.25 percent and zero percent respectively—since November.
But with area-wide inflation slowing to financial crisis levels in May and growth still very anaemic, the time has come to ease further, analysts said.
Eurozone inflation slowed to just 0.5 percent in May, a long way off the 2.0 percent that the ECB defines as price stability.
This has fuelled concern that the single currency area is on the brink of deflation—when consumer prices fall for a broad range of items over a sustained period.
During a period of deflation, people and businesses tend to postpone purchases while hoping for further price declines in the future.
It can thus push an economy into a vicious spiral of falling growth and rising unemployment, and it is notoriously difficult to reverse.
Ongoing risk of deflation
“We expect an interest rate cut, buttressed by a negative deposit rate and possibly further measures to push financing to small and medium-sized enterprises” or SMEs, said Tom Rogers of EY Eurozone Forecast.
“But the case for a wider and more aggressive reflation is becoming more compelling,” he added.
Berenberg Bank economist Christian Schulz insisted, however, that “with confidence indicators signalling continued gradual progress, the banking union project approaching live status and risks like a Ukraine crisis not materialising, there is no need for dramatic action.”
He suggested the ECB would trim the refi rate from 0.25 percent to 0.1 percent and take the deposit rate from zero into negative territory for the first time.
Introducing a negative deposit rate, effectively charging banks when they park money at the ECB, “could encourage some banks to lend more to each other and the real economy,” Schulz said.
Hence, “in theory, the combination could provide a powerful cocktail that boosts bank lending. But negative deposit rates have not been used at this scale before and could have unpredictable consequences,” he cautioned.
“A negative deposit rate is not a policy that has much history in global central banking. There are potential costs,” agreed Deutsche Bank economist Gilles Moec.
These included loss of capacity in banks’ money market operations, a detrimental impact on bank funding and financial instability costs if banks are given an incentive to take more risk, the expert said.
Liquidity measures also option
On top of rate cuts, the ECB could pump more liquidity into the financial system via special long-term refinancing operations or LTROs.
It already did so at the end of 2011 and the beginning of 2012.
But back then, banks did not lend the cash on to the SMEs that form the backbone of the eurozone economy.
So this time round, the ECB is likely to attach conditions to the loans, ECB watchers said.
Another course of action would be to embark on so-called quantitative easing (QE), a policy already pursued by other central banks such as the Bank of England and the US Federal Reserve.
Such a measure was long a taboo at the ECB, because it was seen as an effective licence to print money, which is expressly forbidden in the bank’s statutes.
Nevertheless, “the apparent success of QE in the US, the UK and Japan has reduced the ECB governing council’s aversion to it,” said Berenberg Bank’s Schulz.
However, the ECB’s chief economist Peter Praet had said in May that QE would only be an option “if the economy and inflation develop significantly worse than we expect.”
And that was unlikely to be the case just yet, analysts insisted.