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ECB weighs rate cut as eurozone economy struggles

Source : AP
Last Updated: Wed, May 01, 2013 17:30 hrs

Economists say the European Central Bank could cut interest rates as soon as Thursday because of fears that the euro area's economy isn't recovering — even though top bank officials themselves caution that a cut won't do much good.

Market expectations have risen in recent days of a reduction in the ECB's benchmark rate from its current record low of 0.75 percent when bank's 23-member governing council gathers to debate the issue in Bratislava, Slovakia.

The economy of the 17 European Union countries that use the euro certainly needs a boost. The ECB says the eurozone will shrink 0.5 percent for all of this year and unemployment is at 12.1 percent. Meanwhile, annual inflation is only 1.2 percent, well below the ECB's goal of just under 2 percent. That gives the ECB freedom to cut if it wants to.

The low inflation data make it "virtually impossible" that the ECB will fail to lower the refinancing rate Thursday, said Janet Henry, chief European economist at HSBC. Cuts done at the wrong time can worsen inflation, but it appears there is little risk of that for now.

At 0.75 percent, the ECB rate is still higher than at other major central banks. The Fed is at 0-0.25 percent, the Bank of Japan at 0-0.1 percent, and the Bank of England at 0.5 percent.

ECB president Mario Draghi said at his last news conference April 4 that bank officials "stand ready to act" if their forecast for a recovery later this year appears to not be coming true.

But economists caution a cut isn't a sure thing Thursday. Some say that the bank may wait until its June rate meeting, when it has new staff economic projections to justify any move.

The ECB's refinancing rate determines what banks pay the ECB for credit. This in turn influences a host of other short-term rates charged by banks to consumers and companies. So an ECB cut should, in normal times, make it cheaper for companies to borrow to expand and create jobs.

However there's a problem: Stimulus is not getting through to the places that need it most.

Whatever the decision on Thursday, Joerg Asmussen, the bank's chief of international relations, cautioned last week that the "pass-through" from any cut to the wider economy would be "limited."

Analyst Holger Schmieding at Berenberg Bank says that's one reason a cut "isn't a done deal" although he sees a 60 percent chance for a cut at either the May or June meeting.

"Everyone knows a rate cut won't make much of a difference," he said. "That's why we have it at 60-40 rather than saying it will definitely happen."

The ECB has pointed out that its current record low rates are not being passed on to businesses because banks are struggling with their own financial problems. This is especially the case in countries hardest hit by the eurozone's financial crisis such as Spain and Italy. There, banks have to strike a balance between repairing their own finances so that they are strong enough to withstand any future financial shocks, trying to get other banks to lend to them and deciding whether to make potentially risky investments in companies. This means that many small and medium-sized businesses (SMEs), the chief job-creators in the economy, are not getting affordable credit.

However, a rate cut might offer some help in other ways. It might lower the euro's exchange rate against other currencies. That could help exporters, whose goods become cheaper abroad. And a cut would also lower the cost of ECB emergency credit to the hardest-hit banks. That would take some pressure off their finances so that they could lend more.

The ECB has stayed away from a key tool to help stimulate an economy that is already used by the Fed, Bank of Japan, and Bank of England. Quantitative easing, or the purchase of securities with newly created money, pushes down longer-term interest rates and aims to increase the overall supply of money in the economy. Draghi has said such a step would be difficult for the multinational ECB, since each eurozone member country's debt market is different.

Analysts say the ECB needs to find another way to spur small-business lending. One way would be to encourage banks to bundle small business loans as securities and then to use them as collateral to obtain credit from the ECB. It's not clear whether anything along those lines will be announced Thursday.

Analyst Carsten Brzeski at ING thinks say the ECB may hold off cutting rates so it can first come up with ways to make sure lower borrowing costs are actually passed on. Draghi has indicated the bank is studying possible steps, and mentioned possible involvement by governments and outside agencies such as the European Investment Bank. The EIB already offers reduced interest loans to midsize companies through local banks.

Without such additional measures, a cut "would quickly go up in smoke and could even be regarded as an act of despair," Brzeski said. "It is hard to believe that the ECB would cut rates first and come up with a broader SME funding scheme later."



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