Bloomberg News

Draghi Says Rate Cuts May Have ‘Muted’ Impact on Economy

July 05, 2012

European Central Bank President Mario Draghi

ECB President Mario Draghi said, “The baseline scenario hasn’t changed, although the downside risks are now materializing.” Photographer: Hannelore Foerster/Bloomberg

European Central Bank President Mario Draghi said today’s cut in interest rates to a record low may have only a limited impact on the euro-area economy as it slides toward recession.

“It’s clear that when demand is weak the transmission of price signals to the aggregated economy is muted,” Draghi said at a press conference in Frankfurt after lowering the benchmark and deposit rates by 25 basis points to 0.75 percent and zero respectively. The cuts will reduce the cost of central bank loans for struggling banks, Draghi said.

China also lowered rates today and the Bank of England restarted its asset purchases, adding to a new round of global monetary stimulus. With Europe’s debt crisis curbing growth across the continent and damping the outlook for the world economy, the ECB was under pressure to ease monetary conditions, even though Draghi last month voiced misgivings about the effectiveness of a rate reduction.

“The impact of today’s decision on the euro area will not be large” and “there is now little left for the ECB to do in terms of lowering interest rates,” said Julian Callow, chief European economist at Barclay’s Capital in London. “If the economy does not turn around during the second half, the Governing Council will have to address the case for outright large-scale asset purchases.”

Stocks Drop

The euro fell more than half a cent to a one-month low and traded at $1.2381 at 4:40 p.m. in Frankfurt. European stocks declined. The Stoxx Europe 600 Index (SXXP) fell 0.3 percent after earlier rallying as much as 0.8 percent. Germany’s DAX Index was down 0.4 percent.

The 17-nation euro economy is heading for recession. Unemployment rose to a record 11.1 percent in May, economic confidence slumped to the lowest in more than 2 1/2 years in June, and data yesterday confirmed that services and manufacturing output contracted for a fifth month. The economy will shrink 0.3 percent this year, according to the European Commission.

“We still expect a gradual, slow recovery around the end of the year,” Draghi said. “The baseline scenario hasn’t changed, although the downside risks are now materializing.” Inflation may drop below the ECB’s 2 percent before the end of the year, sooner than previously expected, he said.

Third Cut

Today’s rate cut, predicted by 49 of 64 economists in a Bloomberg News survey, is the first since December and the third since Draghi took office on Nov. 1. Twelve of 22 forecasters in another survey predicted the ECB would lower the deposit rate to zero.

Cutting the benchmark rate will reduce the cost of ECB loans. The ECB has lent banks more than 1 trillion euros ($1.24 trillion) for three years in its so-called Longer Term Refinancing Operations, with the interest determined by the average of the benchmark rate over the period of the loans.

The deposit-rate move may encourage banks to lend to other institutions, companies or households instead of parking excess cash in the ECB’s overnight deposit facility. About 800 billion euros is currently being deposited with the ECB each day.

“It is difficult to foresee what banks will do,” Draghi said. “I don’t expect banks’ behavior to change dramatically in any way.”

The deposit rate has steered market borrowing costs since the ECB started to provide banks with unlimited liquidity after the collapse of Lehman Brothers Holdings Inc. in 2008. That policy removed the need for banks to lend to each other to meet their reserve requirements, pushing down interest rates. Today’s cut may therefore lower the euro overnight index average, or Eonia, which currently stands at 0.33 percent.

What Next?

“The ECB’s decision effectively implements a zero-rate policy in the euro zone,” ABN Amro economists wrote in a note to clients. “Speculation may build that the central bank will follow” the Federal Reserve and the Bank of England “with a quantitative easing program.”

Central Banks around the globe are easing policy in response to Europe’s debt crisis, which has pushed at least seven euro nations into recession and forced five of them to seek bailouts.

The Bank of England, which has been drawn into the scandal over Barclays Plc’s rigging of Libor rates, today raised its target for bond purchases by 50 billion pounds ($78 billion) to 375 billion pounds. China cut rates today and the U.S. and Australian central banks eased monetary policy last month.

No Coordination

Draghi said there was no ECB coordination with the Bank of England or People’s Bank of China on today’s policy decisions “beyond the normal exchange of views.”

In Europe, bond and equity markets rallied last week after euro-area leaders opened the way to recapitalizing banks directly with bailout funds once a single banking supervisor is established. They also dropped the requirement that taxpayers get preferred creditor status on aid to Spain’s crippled lenders.

Yields on Spanish 10-year bonds fell to 6.25 percent yesterday from 6.94 percent on June 28. They rose to 6.77 percent after Draghi’s press conference, and the Italian equivalent jumped to 5.96 percent.

“Although the euro zone is the epicentre of the current global uncertainties, the ECB is still reacting less forcefully to the European risks than many other central banks,” said Holger Schmieding, chief economist at Berenberg Bank in London.

‘Cycle of Fear’

“The ECB neither announced new liquidity initiatives nor dropped any hint that it may intervene again in sovereign bond markets to break the cycle of fear that is engulfing Spain and Italy,” Schmieding said.

Asked if the ECB may implement more non-standard measures, Draghi said: “I can’t see that there are measures that are effective in a highly fragmented market.”

Today’s ECB easing “amounts to little more than a tweaking at the edges as far as the euro zone’s ailing peripheral economies are concerned,” said Nicholas Spiro, head of Spiro Sovereign Strategy in London. “The most salutary effect of the ECB’s rate cuts lies in its impact on the single currency itself. A weaker euro is just what the doctor ordered to help the sickly euro-zone economy in the absence of bolder measures to help stimulate activity.”

To contact the reporters on this story: Jeff Black in Frankfurt at jblack25@bloomberg.net; Jana Randow in Frankfurt at jrandow@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net


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