Draghi Cuts ECB Rates to Combat ‘Prolonged’ Inflation Weakness

Photographer: Ralph Orlowski/Bloomberg

European Central Bank President Mario Draghi speaks during a news conference at the bank's headquarters in Frankfurt on Nov. 7, 2013. Close

European Central Bank President Mario Draghi speaks during a news conference at the... Read More

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Photographer: Ralph Orlowski/Bloomberg

European Central Bank President Mario Draghi speaks during a news conference at the bank's headquarters in Frankfurt on Nov. 7, 2013.

The European Central Bank unexpectedly cut its benchmark interest rate to a record low in a bid to prevent slowing inflation from taking hold in a still-fragile euro-area economy.

With inflation at the weakest level in four years and less than half the ECB’s target, the Frankfurt-based bank halved its key refinancing rate to 0.25 percent in a shift anticipated by just three of 70 economists in a Bloomberg News survey.

“Our monetary-policy stance will remain accommodative for as long as necessary,” ECB President Mario Draghi told reporters in Frankfurt. “We may experience a prolonged period of low inflation.”

The ECB’s first rate reduction since May burnishes Draghi’s reputation as a crisis-fighter and aligns his bank with counterparts such as the Federal Reserve in recently seeking to reinforce rather than retract monetary support. It leaves the euro-area’s main rate just a quarter-point from zero, increasing the likelihood of unconventional tools such as a negative deposit rate if prices slow further or the economy stalls.

“There comes a point where inflation is so weak, and coming in weaker than anticipated, that the case for loosening policy becomes too hard to resist,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London, who predicted the cut.

Almost exactly two years since he marked his arrival at the helm of the ECB by paring interest rates, Draghi’s ECB again sprang into action as the 17-nation economy shows new signs of fragility after emerging from its longest-ever recession in the second quarter.

Deflation Fears

Euro-area inflation surprisingly deteriorated in October to 0.7 percent, below the ECB’s goal of “close to but below” 2 percent, sparking fears of a deflationary cycle. Unemployment of 12.2 percent is the highest level since the currency bloc was formed in 1999, while the euro’s almost 4 percent rise against its major peers this year is challenging exporters. The ECB will better detail its economic outlook when it releases forecasts next month.

The bank kept its deposit rate, which it pays commercial lenders who park excess cash with it, at zero and cut the marginal lending rate, that at which banks can borrow money overnight at any time, to 0.75 percent. That allowed Draghi to say the ECB still had conventional policies to deploy if needed.

Asymmetric Corridor

Policy makers opted for an asymmetric corridor between the ECB’s three interest rates to ensure banks continue to be diligent in planning their refinancing behavior, Draghi said. Reducing the spread between the main and marginal rates would increase the risk that banks move away from regular operations into a facility designed as an emergency fall-back option to cover unexpected financing needs.

The bank also will extend its unlimited offerings of one-month and three-month cash until the middle of 2015, Draghi said. The bank chose not to announce a new long-term refinancing operation in which banks previously borrowed cheaply for up to three years.

“We continue to monitor closely money-market conditions and their potential impact on our monetary policy stance,” Draghi said. “We are ready to consider all available instruments.”

The euro fell the most in almost two years versus the dollar, touching $1.3296, the lowest since Sept. 16. Euro-area government bonds rose, led by Italian and Spanish securities, with Germany’s two-year rate dropping to the least since July. The currency was at $1.3386 at 5:49 p.m. Frankfurt time

Money Market

Given that money-market rates as well as financing costs for companies and households are so low, the rate cut may do little for the economy beyond helping to restrain the euro and proving the ECB’s loyalty to delivering price stability, said Holger Schmieding, chief economist at Berenberg Bank in London.

“The ECB sends a message that it takes the still rather hypothetical deflation risk seriously,” he said. “The ECB does not want an even stronger euro to put additional downside pressures on prices.”

Aside from rate cuts, greater guidance and further liquidity measures, more expansive steps may be harder to countenance. A Fed-style quantitative easing program has repeatedly been ruled out by ECB officials as they are barred by European Union treaties from financing state debt, making large-scale purchases of government bonds open to a legal challenge.

Negative Rates

While Draghi again floated the prospect of a negative deposit rate, policy makers have said that its effects can’t be adequately predicted. A deposit rate less than zero could hurt banks’ profitability by lowering money-market rates, potentially hampering credit supply to companies and households and reducing banks’ incentive to lend to other financial institutions.

Today’s decision comes just three months after some within the ECB said a rate cut was no longer in the debate following signs the economy was strengthening. Other central banks are also reverting to protecting economies from slowdowns in growth and inflation by keeping monetary policy loose.

The Fed decided in September not to taper its asset-purchase program, while the Bank of Canada dropped language last month about the need for future rate increases. Emerging markets from Israel to Chile have cut borrowing costs since the start of September.

“Global growth is picking up, but no central bank is anywhere close to raising rates,” said Trevor Greetham, director of asset allocation at Fidelity Worldwide Investments. “The surprise ECB rate cut underlines our positive outlook for global equity markets.”

Incredibly Imaginative

The unexpected nature of the rate cut underscores Draghi’s reputation as a central banker prepared to tackle the challenges facing the euro head on.

Since he took the ECB’s presidency in November 2011, Draghi has cut rates by a cumulative 1.25 percentage points, pumped unlimited quantities of three-year loans into the financial system and pledged to do “whatever it takes” to defend the euro. That announcement, in the teeth of criticism from some central bankers in Europe, helped draw a line under the region’s debt turmoil.

“I have a huge amount of respect for the Draghi regime,” said Kit Juckes, global strategist at Societe Generale SA in London. “He is incredibly imaginative and innovative, even if he isn’t armed with big-enough weapons.”

To contact the reporters on this story: Simon Kennedy in London at skennedy4@bloomberg.net; Stefan Riecher in Frankfurt at sriecher@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net

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