ECB prepared to cut rates again if necessary

In a surprise move, the ECB cut its main refi rate by 25bps to 0.25% at its council meeting last Thursday. The deposit rate was left unchanged at 0%.

There had been some speculation that the ECB might signal that a rate cut was under active consideration in response to the unexpected sharp fall in inflation to 0.7% in October.

However, few expected that a rate cut would actually materialise last week. Indeed, only last month, some ECB council members felt that the case for a rate cut was not even worth discussing.

In fairness to the ECB, it has been signalling since it started providing forward guidance on monetary policy back in July, that rates could be cut further.

It has repeatedly stated that it expected the key ECB interest rates to “remain at present or lower levels for an extended period of time”.

This forward guidance represented a significant development on the part of the ECB as, throughout its brief history, it had always held to the mantra that it did not pre-commit on rates. The ECB confirmed last week that the forward guidance remains unchanged and, thus, that it still has a downward bias on rates following the latest cut.

The ECB discussed a cut in the deposit rate last week. Mario Draghi emphasised that we haven’t reached the lower bound on rates and, in principle, the ECB could cut rates further, noting that it was technically ready for a move to negative rates.

For now, though, with the deposit rate remaining unchanged at 0%, the cut in the refi rate to 0.25% will anchor short-term interest rates at very close to zero in the eurozone.

On the currency markets, the rate cut saw a continuation of the recent weakening trend in the euro, thereby helping to reverse the gains made by the single currency in the last two months.

The euro was trading at below $1.34 against the dollar at the start of this week, down from $1.35 before the rate cut announcement and a peak of over $1.38 in late October. Against sterling, the euro has fallen to around 83.5p, compared to a recent peak of 85.75p at end October.

Last week’s rate cut was primarily driven by the recent fall in inflation to well below 1%. The decline in inflation has been broad based, with the core inflation rate also dropping below 1%. The ECB does not expect deflation or falling prices. However, it believes that recent price developments mean that the eurozone now faces a protracted period of very low inflation.

This change in the inflation outlook provided enough grounds for a majority of the ECB council to support a cut in rates last week. The decision was opposed, though, by a number of council members, according to media reports.

Rates are likely to remain on hold for some time. A move to negative rates would be a big step for the ECB. It only seems likely if inflation continues to fall and the economy moves closer to outright deflation, or moves back into recession. This would increase the risk of deflation, given the current very low inflation rate.

The ECB, though, is not expecting either of these scenarios to materialise. It expects that, while inflation will remain low for a prolonged time, it will eventually rise gradually to close to 2%. Meantime, it expects the moderate recovery in economic activity to continue.

There will be a lot of interest in the ECB’s next set of macro-economic forecasts, which are due to be published early next month. What’s clear is that the ECB is prepared to act if the economy shows signs of deviating from its forecasts. Furthermore, very low interest rates are here to stay for a long time.

* Oliver Mangan, chief economist, AIB


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