Rare ECB move signals strange economic times

Mario Draghi: "Together, the measures will contribute to a return of inflation rates to levels closer to two per cent"

The European Central Bank has cut interest rates to record lows in a bid to prevent deflation. The negative interest rate of minus 0.1% - that is, charging commercial banks to park their surplus funds overnight - is perhaps the most striking element in this package.

Negative rates do happen now and then, but they are very rare and often a sign of some sort of financial or economic stress. That certainly applies in this case, where the eurozone economic recovery is unconvincing and risks being undermined by deflation or falling prices.

One source of weakness is declining bank loans to the private sector. The negative rate might encourage banks to lend more, because it doesn't apply to the reserves they are required to keep at the ECB. The more they lend, the bigger those requirements - and so the smaller the sum that will be subject to this negative rate.

Here's another way of looking at it: if banks want a comfort blanket of extra funds on deposit at the ECB, they will have to pay for it. And that is a potential problem. As it imposes a cost on them it might affect their profitability and they are still not in robust health.

In truth the impact of a negative deposit rate is uncertain, so proceeding with this move does underline the fact that the ECB is concerned enough to be ready to take some steps into the unknown.

There is another possible benefit from the negative deposit rate - and the other rate cuts. They could weaken the euro. When Denmark did much the same thing in 2012, the aim was to stop the currency rising - it is pegged to the euro, so when investors seeking refuge from the storms in the eurozone bought the Danish krone, it produced upward pressure on the currency that was unwelcome. The negative interest rate seems to have helped stabilise the krone.

In the case of the eurozone, a weaker euro would have two advantages. It would help exporters compete. It would also make imports more expensive. Normally that is an unwanted side-effect of a declining currency, but when inflation is too low that really is helpful. It just reminds us that we are (still) living in strange economic times.

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