Last Thursday the European Central Bank announced rate cuts as expected to the deposit and refinancing rates within the Eurozone area. The deposit rate is particularly interesting. At -10bps banks now have to pay a small fee to store their money in the central bank. The ECB benchmark interest rate has also been cut by -0.1% from 0.25% to 0.15%. The EURO weakened against the major currencies once the news was announced, with GBPEUR currently trading around €1.23776
What does this mean?
The Eurozone is undergoing a continual and sustained period of recovery and this was seen by many economists as an expected movement by ‘Super Mario’ Draghi and his policy makers to assist in the gradual improvement of the economy.
The ECB took this decision to deter banks from storing money in the Central Bank but to encourage banks to lend to small and medium enterprises to help grow their businesses. In a perfect scenario, companies would borrow from banks to assist in their expansion. Expansion would lead to an increase in demand for workers, pushing up the cost of real wages. This means an increase in the cost of goods/services to the company, translating to an increase in price for the customer. This then from a macroeconomic perspective would translate to an increase in inflation (currently at a low 0.5% for the zone). A weaker Euro also provides opportunities for growth in the external channel (imports & exports), a weaker Euro means that channel is more favourable to people outside the Eurozone.
There are concerns that the current recovery isn’t sustainable, even though the Eurozone economy is growing after many years of recession – so the actions that have been taken along with what has been termed ‘Long Term Refinancing Operations’ where banks are able to use their illiquid assets as collateral for cheap loans up to 3 years, are being seen as the solution to supporting the economic growth of the zone, which was only 0.3 in q1 2014. This would also guard against the possibility of a liquidity trap, where businesses, individuals and banks hold on to their money in times of deflation as the value naturally increases due to the fall in prices of goods and services. The illiquidity means that no cash is being invested into the economy, affecting growth.
Let’s see what happens.