The ECB cut its main refinancing rate by 25bps to 0.25%. While most analysts expected a cut, it came slightly earlier than expected. The ECB deposit deposit facility, which allows eurozone banks to park their excessive liquidity overnight, effectively sets the floor for money market rates when liquidity is very ample, was unchanged. As a result, today’s cut is more about signalling than about actual policy.
In the press conference ECB President Draghi warned inflation would remain low for a prolonged period before rising gradually back within the ECB’s target of a rate “below but close” to 2 per cent. As expected, Draghi also announced an extension until at least mid-2015 in the provision of unlimited liquidity to eurozone banks, in its open market operations.
Draghi also left the door opened for using further liquidity boosting instruments. Markets have been particularly focused on the possibility that the ECB will lower deposit rates to negative territory, from 0% currently. Thought the ECB has in the last few months appeared to be less concerned about the distortion caused by negative rates, we still think that it is likely that it will only use that instrument only as a last resort. The idea behind negative deposit rates is that commercial banks would need to actually pay to leave excess liquidity with the ECB. This should support banks’s willingness to lend more to each other, and eventually to their customers, therefore supporting the recovery. Moreover, negative rates could push down the euro boosting competitiveness.
However, there are significant risks attached to such a policy. First and foremost, very low or negative nominal rates may be very punishing from savings, that are an important source of funding for investment. Negative rates may therefore contribute to lowering potential growth. Second, far from pushing banks to lending more, negative rates may be an incentive for banks to repay the long term liquidity that was provided by the ECB a couple of years ago, further affecting lending. Finally, the uncertainty about the actual effects of negative rates may cause added volatility in the markets.
Balancing the pros and cons, we believe that the ECB will leave the deposit rate at 0% for the foreseeable future.