The European Central Bank (ECB) will charge banks in the eurozone for keeping cash on deposit in an unprecedented bid to get money flowing and tackle the threat of deflation.
ECB President Mario Draghi slashed the official interest rate – what banks pay to borrow – to 0.15pc yesterday. More radically it introduced a “negative interest rate” on overnight deposits from banks.
That means euro-area lenders, including banks here, will be punished for keeping cash on deposit with the central bank instead of lending it out.
The central bank will charge lenders 0.1pc for parking funds overnight. Both measures are aimed at keeping cash flowing through the “real economy”.
Mr Draghi said interest rates will stay low for a prolonged period.
Denmark and Sweden have previously introduced “negative interest rates” but yesterday’s move is the first time a major global central bank has taken the step, including Japan which avoided it even during its so-called lost decade.
The interest cuts are part of a suite of measures that also includes cheap long-term finance for banks that commit to lend to business.
With European economies moribund since the economic crisis, deflation has emerged as a major threat.
The risk with deflation is that falling prices encourage consumers and businesses to delay making purchases because they think prices will fall – a factor that becomes self-fulfilling.
It’s a particularly big danger for economies like ours that desperately need growth to cope with the legacy of debt built up in the first decade of the single currency.
The ECB is making €400bn in cheap four-year loans available to banks that commit to use the funds to boost lending to businesses. The so-called targeted longer-term refinancing operations will be carried out in September and December.
For Ireland, the initial potential lending boost could be up to €7bn, according to economist Austin Hughes at KBC Bank.
The full amount of cash is unlikely to be drawn down by banks here as it is difficult to see new lending running ahead of maturing loans advanced in the boom.
In fact mortgage lenders here, in particular the likes of Permanent TSB and Ulster Bank that have big books of tracker mortgages linked to the official interest rate will see their margins hit by the ECB measures.
Yesterday Mr Draghi stopped short of quantitative easing – a process that involves trying to drive up prices by printing cash for large-scale asset purchases. But, he said action on that score will come if necessary and ordered preparatory work to get under way. “We think it’s a significant package,” Mr Draghi said. “Are we finished? The answer is no.”
In the meantime, however, bonds bought in the market by the ECB under its existing purchase programmes will no longer be “sterilised” meaning the amount of cash in circulation will be allowed to creep up. “Now we are in a completely different world,” Mr Draghi told a news conference, citing “low inflation, a weak recovery and weak monetary and credit dynamics”.
“If required, we will act swiftly with further monetary policy easing,” he said, adding that the policy-setting Governing Council was unanimous in its commitment to use unconventional instruments if needed.
The ECB is forecasting inflation to be as low as 0.7pc this year, 1.1pc next year and 1.4 pc in 2016. That is far below the target to keep inflation below-but-close-to 2pc.
While markets initially welcomed the news – as seen in a sharp decline in the euro against the dollar – that enthusiasm waned. The euro finished more or less unchanged.
The euro fell to a four-month low of $1.3505, down about one cent, after his statement. European shares rose and yields on the government bonds of stressed eurozone countries fell.
In France President Francois Hollande welcomed the central bank’s decision. German finance minister Wolfgang Schaeuble, said low interest rates were not a long-term solution. Any action seen as punishing savers is controversial in Germany.
Economist Hans-Werner Sinn of the Ifo institute in Frankfurt said the moves smacked of desperation and would not work.
“This is a desperate attempt, with ever cheaper money and penalty rates on deposits, to shift capital flows to southern Europe in order to stimulate growth there,” he said. (Additional reporting Reuters)
Why such ground-breaking action – and will it work?
* What happened yesterday?
The ECB has cut the official eurozone interest rate to an all-time low of 0.15pc. The deposit rate paid on cash parked by banks with the Central Bank was cut to minus 0.1pc.
A new €400bn credit package for banks to pass on to business borrowers was also launched. An Irish bank could borrow from the ECB for as little as 0.25pc for four years under the scheme.
Officials in Frankfurt have begun work on an asset-purchase plan – so-called quantitative easing (QE) – which would pump even more cash into the euro-area economy.
The economic outlook for the euro area is getting worse, meaning what little growth we have seen is incredibly fragile. Deflation – a vicious circle where falling prices cause people not to invest, driving prices down further – is a real risk.
Normal Central Bank tools like cutting interest rates have failed to turn things around.
* Why not?
Loose money has driven down the cost of borrowing for countries – including Ireland – because the bond market has been very responsive to ECB action. But most businesses in Europe, especially smaller companies, rely on banks for loans and that sector is holding on to cash. In ECB jargon, the transmission mechanism to get cash from it to the end borrowers has broken down.
A couple of reasons. Stricter lending rules since the crash actually make it harder for banks to lend. Banks may also be tempted to hang on to cash ahead of EU-wide stress tests later this year, or take cheap Central Bank loans and lend it to governments instead of industry or households.
* Will the latest measures work?
Who knows; we are in uncharted territory with some of these measures. There is also a sense that the measures announced yesterday are just the start of a more radical new direction for the ECB, which Germany and some other reluctant countries are being eased into.
* What else is on the cards?
Expect to see the ECB launch a scheme to buy up bundled-up packages of small and medium enterprise (SME) loans from banks through so-called asset-backed securitisation vehicles later in the year.
It will be controversial because securitisation was blamed by many for putting too much cheap credit into the global financial system before the crash.