Eurozone struggling to escape liquidity trap

The ECB cut its refi interest rate by 25 basis points to 0.5%, the first reduction in rates since last July when both the refinancing rate and deposit rates were cut by 25 basis points.

With the deposit rate at zero and some resistance within the ECB Council to reducing rates further, the most that was expected at last week’s meeting was a 25bps cut in the refi rate.

ECB president Mario Draghi indicated that there was a very strong prevailing consensus on cutting rates, suggesting that the decision was not unanimous.

There were strong hints from Mr Draghi at the previous month’s ECB press conference that a rate cut was under consideration. Hence, last week’s move was no surprise, especially after the string of weak eurozone economic data released over the past month.

What was a surprise, though, were the indications from Mr Draghi last week that the ECB may cut rates again if the economy remains weak. Indeed, he did not rule out the possibility of even negative interest rates via a cut in the deposit rate to below zero.

The deposit rate is now the key market interest rate. His remarks had quite an impact, with the euro falling and interest rate markets rallying.

The eurozone economy has been very weak for quite some time now. It faltered badly during 2011, with the economy going back into recession in the final quarter of that year. The economy continued to contract right through 2012, with a particularly sharp fall in output in the final quarter of last year.

It would seem on the basis of available data that eurozone GDP contracted again in the opening quarter of 2013. This would represent six consecutive quarters of declining output, with no clear sign that an upturn in activity is imminent.

Furthermore, this is a double-dip recession, coming very soon after the very severe recession of 2008-09.

The most recent data from the eurozone show that the economy remains very weak. The CPI rate fell to 1.2% in April from 1.7% in March, a much bigger fall than expected. The unemployment rate also rose above 12% in March.

Growth in M3 money supply continued to slow in March, while private sector credit continued to contract. Meanwhile, leading indicators of business activity continued to weaken in April, including in the core economies.

A continuation of these trends is likely to be required for the ECB to ease policy further and cut rates again. Thus, incoming economic data in the next couple of months will be closely watched. A negative deposit rate would be a big step for both the ECB and the banking system.

However, Mr Draghi said that the ECB is technically ready if it decides to move in this direction.

Meanwhile, in a further move in terms of keeping policy very accommodative, the ECB also announced it would continue to conduct full allotment, fixed-rate refinancing operations until at least Jul 2014. This is aimed at convincing markets that ample liquidity will continue to be provided at low rates by the bank until then at least.

The ample liquidity has been a key factor in the strong rally by financial markets over the past year. Bond yields have fallen sharply in both core and peripheral eurozone countries, with stock markets also rising strongly. Ten-year German bond yields have fallen close to 1%.

What is really required, though, is for the marked fall in interest rates and ample liquidity to begin to impact on the real economy and generate a pick-up in activity. This is proving difficult, though, because of ongoing severe fiscal tightening at a time of continuing deleveraging in the private sector. The eurozone, then, appears to be caught in a liquidity trap.

* Oliver Mangan, AIB chief economist