The European Central Bank should keep interest rates low for the foreseeable future and may need to cut them further given the risk of deflation, the International Monetary Fund said.
Euro-area inflation will slow to 1.6 percent in 2013 “and risks from domestic wages and profits are to the downside,” the Washington-based IMF said in its World Economic Outlook today. “The probability of falling prices is unusually high, reaching almost 25 percent. This projection gives the ECB ample justification for keeping policy rates very low or cutting them further.”
While the Frankfurt-based ECB cut its benchmark interest rate to an historic low of 0.75 percent on July 5 and took its deposit rate to zero, President Mario Draghi signaled last week that further easing may have only a limited effect on the economy. The IMF warned that Europe’s sovereign debt crisis, now in its third year, could escalate and that the economic outlook has worsened.
The IMF cut its forecast for growth in the euro area next year to 0.2 percent from its July prediction of 0.7 percent and said the economy will contract 0.4 percent this year as governments continue to reduce spending. It lowered its 2013 growth forecast for Germany, the region’s largest economy, to 0.9 percent from 1.4 percent.
Unless the ECB’s announcement of an unlimited bond-purchase plan is “followed up with more proactive policies by others,” the latest economic projections “may once again prove overly optimistic and the euro area could slide into the weak policies scenario, with deleterious consequences for the rest of the world,” the IMF said.
The ECB’s bond-buying plan, which pledges unlimited support for countries that sign up to economic reforms as part of a bailout from Europe’s rescue fund, will help transmit monetary policy to the affected regions, the IMF said.
Still, “the possibility that the euro-area crisis will escalate remains a major downside risk to growth and financial sector stability until the underlying issues are resolved,” it said.