ECB Cuts Main Rate to Record Low, Deposit Rate to Zero

ECB Cuts Main Rate to Record Low, Deposit Rate to Zero
The European Central Bank (ECB) headquarters in Frankfurt. Photographer: Hannelore Foerster/Bloomberg

The European Central Bank cut interest rates to a record low and said it won’t pay anything on overnight deposits as the sovereign debt crisis threatens to drive the euro region into recession.

Some “downside risks to the euro-area economic outlook have materialized,” ECB President Mario Draghi said at a press conference in Frankfurt after lowering the main refinancing rate and the deposit rate by 25 basis points to 0.75 percent and zero respectively. “Economic growth in the euro area continues to remain weak with heightened uncertainty weighing on both confidence and sentiment,” Draghi said.

With Europe’s debt crisis curbing growth across the continent and damping the global outlook, the ECB was under pressure to ease monetary conditions, even though Draghi last month voiced misgivings about the effectiveness of a rate reduction. While today’s moves may not stimulate demand, they will lower borrowing costs for struggling banks and could build on the confidence boost euro-area governments delivered last week when they took steps toward a deeper economic union.

‘New Territory’

“The benchmark rate doesn’t really matter at the moment, but cutting the deposit rate all the way to zero takes the ECB into new territory,” said James Nixon, chief European economist at Societe Generale SA in London. “If you can kick-start the money market you go a long way to addressing some of the funding problems that banks face. That may free banks to lend to the economy.”

Today’s rate cut, predicted by 49 of 64 economists in a Bloomberg News survey, is the first since December and the third since Draghi took office on Nov. 1. Twelve of 22 forecasters in another survey predicted the ECB would lower the deposit rate to zero. The euro fell more than half a cent to $1.2402 at 3 p.m. in Frankfurt.

Central banks around the globe are easing policy in response to Europe’s debt crisis, which has pushed at least seven euro nations into recession and forced five of them to seek bailouts.

Bank of England

The Bank of England, which has been drawn into the scandal over Barclays Plc’s rigging of Libor rates, today raised its target for bond purchases by 50 billion pounds ($78 billion) to 375 billion pounds. China cut rates today and the U.S. and Australian central banks eased monetary policy last month.

Draghi said there was no ECB coordination with the Bank of England or People’s Bank of China on today’s policy decisions “beyond the normal exchange of views.”

In Europe, bond and equity markets rallied last week after euro-area leaders opened the way to recapitalizing banks directly with bailout funds once a single banking supervisor is established. They also dropped the requirement that taxpayers get preferred creditor status on aid to Spain’s crippled lenders.

Yields on Spanish 10-year bonds fell to 6.25 percent yesterday from 6.94 percent on June 28. They rose to 6.53 percent this morning.

A deposit rate of zero may encourage banks to lend to other institutions, companies or households instead of parking excess cash in the ECB’s overnight deposit facility. About 800 billion euros ($1 trillion) is currently being deposited with the ECB each day.

Market Rates

The deposit rate has steered market borrowing costs since the ECB started to provide banks with unlimited liquidity after the collapse of Lehman Brothers Holdings Inc. in 2008. That policy removed the need for banks to lend to each other to meet their reserve requirements, pushing down interest rates. Today’s move may therefore lower the euro overnight index average, or Eonia, which stood at 0.33 percent yesterday.

“Cutting the deposit rate reduces bank lending rates, and indirectly it helps the economy,” said Martin Van Vliet, senior euro-area economist at ING Bank in Amsterdam. “It’s not a silver bullet, but everything helps.”

Draghi said now that the deposit rate is at zero, “expectations of further easing of monetary policy in case price stability considerations were to warrant it” in itself “has a positive effect, a stimulus effect.”

ECB Loans

Cutting the benchmark rate will lower the cost of ECB loans. The ECB has lent banks more than 1 trillion euros for three years in its so-called Longer Term Refinancing Operations, with the interest determined by the average of the benchmark rate over the period of the loans.

Draghi last month questioned the effectiveness of cutting rates, arguing that “price signals” have a “relatively limited immediate effect” amid financial-market tensions.

Today he said policy makers have more information and “we see that credit flows remain weak.”

“We still expect a gradual, slow recovery around the end of the year,” Draghi said. “The baseline scenario hasn’t changed, although the downside risks are now materializing.”

Unemployment rose to a record 11.1 percent in May, economic confidence slumped to the lowest in more than two and a half years in June, and data yesterday confirmed that services and manufacturing output contracted for a fifth month. The euro economy will shrink 0.3 percent this year, according to the European Commission.

“It does look like it is going to be a somewhat rocky 2012 for the euro-area economy,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London. “At the same time, I don’t think the ECB are convinced that conventional policy has that much of an impact.”

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