The European Central Bank surprised financial markets by paring back its key interest rates to new all-time lows to ward off deflation, and it also cut growth forecasts.
The European Central Bank surprised financial markets by paring back its key interest rates to new all-time lows to ward off deflation, and it also cut growth forecasts. - 
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Whipping out the big guns, monetarily speaking.

Europe’s Central Bank announced today it was stepping on the economic gas, giving the eurozone a shot, or whatever your choice of analogy. 

More specifically: It lowered its deposit rate for banks to negative-0.2 percent from negative-0.1 percent. 

“Nobody except the ECB has flirted with negative interest rates. Even Japan. This is unprecedented,” says Marc Chandler, Global Head of Currency Strategy at Brown Brothers Harriman.

A positive interest rate means banks earn money on what they hold on reserve with a central bank — whereas a negative interest rate means banks have to pay to park their money there. The idea is that this will push money out into the financial system and promote lending. 

Secondly, the ECB said it would start purchasing asset-backed securities, much like the United States Federal Reserve and the Bank of England has done (the quantitative easing strategy) to promote lending and inject money into the stock market and economy.

Why now?  

Second-quarter GDP growth flat-lined in Europe.

“The eurozone economy is failing to recover in the way that the U.S. or U.K. economy has been recovering,” says Andrew Lilico, head of Europe Economics. “You have countries with 25 percent and up unemployment that are still very much trapped. While it just got out of recession, the economy has gone from contraction to stagnation.” 

One symptom of this, says Chandler, has been that “lending has collapsed in the euro area as banks try to rebuild balance sheets and deleverage.”

The European Central Bank is preparing to take on new regulatory authorities. As banks brace for future stress tests, they have cut back on lending. At the same time, says Chandler, consumers and small businesses aren’t inclined to borrow.

Plus, the inflation rate has inched down over the past few months, reaching precariously close to zero. 

“We had the inflation rate of eurozone countries running at 0.5 percent  in June, 0.4 percent in July, 0.3 percent in August. It has been gradually declining,” says Abdur Chowdhury of Marquette University and chief economist at Capital Market Consultants. 

Chowdhury predicted the ECB’s move, contrary to many analysts who assumed the bank would wait until later this year to act. “The major concern that people have is they don’t want deflation, because that would create a vicious cycle” of economic contraction.

Early ECB assessments have pointed out that drops in inflation were occurring for “good” reasons — fuel costs were falling, for example. But Chowdhury says even if that’s true, the fact that the GDP isn’t benefiting from those good reasons makes the threshold of 0 percent inflation and the risk of crossing over into deflation territory dangerous, because deflation is a difficult problem to solve once it starts.

Why not sooner?

Hindsight is 20-20, but many economists argue some things are just plain easy to see coming.  “They should’ve done it four or five years ago,” says Lilico, a sentiment Chowdhury echoes.  

“The governing council that makes the decision has one member for each of the eurozone countries,” says Chowdhury. “These member look at national interest first and the interests of the eurozone second, to be honest.”  Still, he says, “better late than never.”

Will it work?

Chandler, who also anticipated the ECB’s move, says “probably on the margins.” He expects inflation to bottom out in the next few months, but not cross over into deflation territory, and he says the stimulus, rate adjustment and resulting slide in the euro may all contribute to this. 

As for what this means for the U.S., Chandler says, “It makes us look like a high yielder; it makes the U.S. look more attractive."

European investors may opt to put money into U.S. bonds and securities at the same time the Federal Reserve stops doing so. This could keep yields on bonds from falling precipitously as the Fed exits its stimulus. 

As rates fall and yields in Europe shrink, the euro will become a less attractive currency to hold and will fall in value against the dollar (1 percent shortly after the ECB’s news was announced). This means European goods will be cheaper for Americans to buy, but it also means Europe will become less hungry for American exports as they become more expensive in Europe.