Macroeconomics

11 June 2014

DRAGHI’S BOLD MOVE 

The European Central Bank raised eyebrows on June 5th when it announced it was adding negative interest rates to its arsenal to fight deflation.

As part of a series of measures to lift the inflation rate and prompt more lending in the real economy, the ECB said it would impose a 0.1% annual charge on funds deposited at the central bank, instead of paying banks interest on their deposits. The idea is that institutions will prefer to receive interest from borrowers rather than to pay for the privilege of depositing their cash.

The challenge is that annual inflation in Europe is actually barely above zero, compared with the ECB’s target of 2%. The sluggish European economy risks sliding into deflation, where individuals and businesses hoard cash rather than spend it because they expect prices to be lower in the future. This reduces economic activity, adding to downward pressure on prices.

The ECB stopped short of the “asset purchase” steps taken by the Bank of England and the US Federal Reserve, known as “quantitative easing,” to provide the banking sector with liquidity and, hopefully, encourage lending. Both the BoE and the Fed are winding down monetary expansion as their economies grow. With the eurozone economy sputtering in 2014, however, the ECB is looking for ways to restart activity.

In 2012, ECB President Mario Draghi restored investor confidence by declaring the ECB would do whatever it takes to save the euro, and last week he promised a similar commitment to stave off deflation.

Economists are divided on whether interest rates near or below zero will provide enough fuel to get the eurozone economy moving again. If not, Draghi says he is ready to look at other measures.