European Central Bank trims key interest rate to record low
The euro sculpture stands in front of the European Central Bank, ECB, in Frankfurt, Germany, June 11, 2013. (AP / Michael Probst)
David McHugh, The Associated Press
Published Thursday, September 4, 2014 8:24AM EDT
Last Updated Thursday, September 4, 2014 2:02PM EDT
FRANKFURT, Germany -- The European economy needs help. Most people didn't expect it would arrive quite this quickly.
The European Central Bank cut interest rates Thursday and announced a program to pump money into the economy and stimulate lending by buying bundles of bank loans.
The majority of analysts didn't think the ECB would move this soon. The reason for the stepped-up action: the eurozone's top monetary authority is worried. The 18 countries that use the euro showed no economic growth in the second quarter after four quarters of meagre expansion. Inflation is only 0.3 per cent annually, well below the ECB's goal of just under 2 per cent and another sign of economic weakness. And inflation expectations are slipping.
Here's a look at what the bank did and how much it might help.
ZEROING IN: The ECB nudged its benchmark interest rate about as close to zero as it can get, from a record low 0.15 per cent to 0.05 per cent. This rate determines what banks pay when they borrow from the ECB. Usually, this is the Big Kahuna: the rate that determines the cost of short-term credit all across the economy.
But the economy is so slack that there's not a lot of lending going on.
And rate cuts have less effect as rates get near zero. So this is mostly symbolic, and a statement of resolve to do what's necessary.
CREDIT TAP: The ECB went beyond the benchmark rate and turned to an unconventional step to push for more credit. Draghi said the ECB is ready to buy asset-backed securities, or ABS -- bonds based on bank loans such as mortgage loans, car loans and credit to businesses.
Most people outside the financial industry first heard about asset-backed securities when one variety -- complex bonds based on mortgages -- confused investors and ravaged the banking system in 2007-2008. Yet it's precisely this kind of bond -- the simpler, less risky ones -- that the ECB wants to see more of.
By buying these assets, the ECB gives banks incentives to make the loans from which they're constructed. That's key in Europe, because most companies get the credit they need to operate from banks, not by issuing bonds as they do in the U.S.
Ultimately, it's a way of using financial markets to make more money available for companies and consumers.
The amount of ABS in Europe's markets shrank from 1.2 trillion euros ($1.6 trillion) in 2008 to 239 billion euros in 2013. The hope is that more bonds will be issued if banks know there's a ready buyer for ABS. That would be the ECB.
NOT THERE YET: The ECB stopped short of large-scale purchases of government bonds, or full-scale quantitative easing. The U.S. Federal Reserve has done that, and watched unemployment fall steadily -- although how much credit the bond purchases should get is disputed.
Government bonds are more abundant and mean a chance for even more stimulus. But buying them is more complicated in an 18-country currency union.
Analyst Marco Valli at UniCredit says, "The ECB will (reluctantly) get involved into full-blown QE only in a worst-case scenario" where inflation expectations sag further.
THE RIGHT MEDICINE? It's hard to gauge what impact Thursday's measures will have on the economy over time. The ECB, for one thing, has not said how much it would spend on the program.
"Little is known about just how many assets the ECB will be able to buy and what impact this will have on the economy," said Chris Williamson, chief economist at Markit.
Thursday's steps could help if they drive down the euro's exchange rate. Rate cuts can weaken a currency -- and the euro sagged to $1.2995 after Thursday's news, its first time below $1.30 since July 2013. That will help European exporters by making their goods cheaper overseas. It's also good news for the ECB, as a weaker euro can help raise the rate of inflation by making imports more expensive.
The market reaction is in part due to the surprise factor. Most analysts thought the ECB would wait a few months to see what effect an earlier raft of stimulus measures announced in June would have. Back then, the ECB cut rates and said it would offer more cheap loans to banks tied to their lending to businesses. The first of those loans are to be allocated on Sept. 18.
HELP NEEDED: Draghi was adamant that everything the ECB is doing won't help if governments won't get into the act as well.
Among the more important reforms is cutting rules limiting hiring and firing to make it easier for companies to take on workers. Others include cutting high taxes and reducing the paperwork and bureaucratic permissions needed to start a business.
As Draghi put it: "We can provide as much monetary stimulus as we want, as much availability of credit as we want, but if the person who has planned to use this credit for a new business has to wait eight months before he or she can open this new business, and then once she does it, she has to pay lots of taxes, then she will not apply for credit."