ECB cuts rates below zero to bolster euro zone economy

The ECB has cut interest rates to record lows today, imposing negative rates on its overnight depositors to cajole banks into lending more and to fight off the risk of Japan-like deflation.

The cut, the first time the ECB has deployed a negative deposit rate which effectively charges banks to deposit overnight, was a response to a slowdown in inflation far below the ECB’s target and to weak euro zone lending.

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That is a combination that risks dragging the bloc into an economic quagmire.

The ECB lowered the deposit rate to -0.1 percent, meaning it will effectively charge banks for holding their money overnight. It cut its main refinancing rate to 0.15 percent, and the marginal lending rate – or emergency borrowing rate – to 0.40 percent.

Markets sent the euro to a four-month low of $1.3575 after the news.

“Further monetary policy measures to enhance the functioning of the monetary policy transmission mechanism will be communicated in a press release to be published at 3.30 p.m. CET today,” the ECB said in a statement.

Investors first turn their attention to ECB President Mario Draghi’s 1230 GMT news conference at which he is widely expected to present other measures to complement the rate move.

“This is a baby rate cut – a tweak to the policy stance,” said RBS economist Richard Barwell, adding that Draghi needed to announce a bundle of measures to avoid disappointing markets.

Economists polled by Reuters had expected the ECB to cut the refinancing rate to 0.10 percent from 0.25 percent and the deposit rate to -0.10 percent from zero, as well as launching a refinancing operation aimed at funding firms.

Reuters reported last month that the ECB was preparing a package of policy options for this week’s meeting, including the rate cuts and targeted measures with a view to boosting lending to small- and mid-sized firms (SMEs).

“I think expectations are very high,” Barwell added. “To exceed them, I think he (Draghi) is going to have to talk up the prospect of asset purchases in the near future.”

Just hours before the ECB policy decision, a Bank of Japan policymaker sounded a warning, saying the euro zone should not take lightly the potential danger of slipping into a Japan-style deflationary period.

In an April 24 speech, Draghi set out three broad scenarios for ECB policy action and included the possibility of a broad-based asset-purchase program in the event of a worsening of the medium-term inflation outlook.

Such a program is unlikely for now, however, even though euro zone annual inflation unexpectedly slowed to 0.5 percent last month, figures published earlier this week showed. The ECB targets inflation of close to but below 2 percent.

Draghi will present updated inflation and growth projections from ECB staff at his news conference. In March, the forecasts showed it would take 2-1/2 years for inflation to get near the ECB’s target. A weaker outlook will support robust ECB action.

The ECB is widely expected to accompany the rate cuts with other measures such as offering banks cheap, long-term funding – a so-called LTRO – on condition that they use this financing to further lending to companies.

Euro zone inflation has been stuck in what Draghi has called “the danger zone” below 1 percent since October, mainly because of weaker commodity and food prices, but also because of wage and other adjustments in euro zone crisis countries.

The stronger euro exchange rate exacerbates these dynamics.

At the same time, record low interest rates are still not feeding through evenly to companies across the currency bloc. Companies in Portugal, for example, are paying on average 5.4 percent on loans compared with 2.2 percent in Finland or France.

This particularly affects smaller companies, which rely strongly on bank funding and make up the bulk of the economy.

Another possibility is the for ECB to extend its provision of unlimited access to central bank funding beyond July 2015.

U.S.-style quantitative easing (QE) – money printing to buy assets – is likely to remain someway off, however, as it is the last weapon at the ECB’s disposal and the barriers to using it are high for the hawkish contingent on the Governing Council.

“We expect the big QE-bazooka to remain in the closet,” said ING economist Carsten Brzeski.