Europe's central bank weighs anti-deflation steps

Updated: 2014-06-05 10:10


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FRANKFURT, Germany - The European Central Bank is all but certain Thursday to cut interest rates to try to boost ultra-low inflation and strengthen the wobbly recovery in the 18 countries that use the euro.

Analysts say the bank might take its stimulus efforts farther and announce extraordinary steps to get credit moving to struggling businesses.

The ECB has been under pressure to act, especially after a report this week showed that inflation in the eurozone dropped more than expected last month to 0.5 percent - further evidence of a slack economy.

Excessively low inflation, if it persists, could become a serious economic threat. It could cause businesses and individuals to delay spending indefinitely as they await ever-lower prices. It could also make it harder for companies and countries to pare their heavy debt loads left over from the eurozone's financial crisis.

The ECB maintains a target inflation rate for the eurozone of just below 2 percent. Fears have arisen that the continent's excessively low inflation could slip into deflation - an outright fall in prices. Deflation can stall an economy, as it did in Japan for much of the past two decades.

It's a trap that's hard to escape, which helps explain why Mario Draghi, the ECB's president, has strongly hinted that the central bank will take unusual action this week.

Waning energy prices and a strong euro, which has reduced prices of imports, have been blamed for much of the fall in inflation. In countries such as Greece, whose government has held back government spending and state salaries in return for bailout loans from other countries, falling prices have been a consequence of official policies.

Here are some of the tools the ECB's 24-member governing council could decide to use at the meeting in Frankfurt, Germany.

Rate Cut

Most analysts think a cut in the bank's interest benchmark, the refinancing rate, from its current record low of 0.25 percent is a near certainty. That's the rate at which banks can borrow from the ECB. It heavily influences market rates at which banks lend to each other.

If banks pass on those lower rates to customers, a cut in the refinancing rate can mean lower borrowing costs across the economy. It's already very low, so another cut might only bring marginal help. With eurozone growth at only 0.2 percent in the first quarter, any help however is welcome.

Perhaps the biggest help from rate cuts would be holding down the euro's exchange rate against the dollar. Lower rates reduce investor returns, and thus can reduce demand for investments in a particular currency. Draghi's statement May 8 that the bank was "not resigned" to the current low inflation and was "comfortable" taking action in June made markets think a rate cut was a sure thing - and sent the euro down from 2 { year highs around $1.40 to around $1.36.

In fact, markets have gone so far they may have set themselves up for disappointment.

Holger Schmieding at Berenberg Bank said a rate cut on its own "without any further initiative could be a negative surprise." Markets, he added, "may then partly erase the moves of the past four weeks."

Going Negative

A further, and more unusual step, would be a negative interest rate for excess funds that banks deposit at the ECB. Currently the rate is zero. The idea is, a negative rate of, say, 0.1 percent, could push banks to lend that money instead of stashing it away. Yet the consequences are unpredictable. It could burden bank finances at a time when the ECB is pushing banks to shed bad loans and assets and strengthen their finances.

Big Bazooka

Many economists have said pumping large amounts of newly created money into the financial system through large-scale bond purchases is the best way to reflate the economy. After all, that is what the U.S. Federal Reserve and the Bank of England did.

However, it's considered the least likely. The measure faces legal, political and practical obstacles in an 18-country currency union. For one, buying government bonds raises the question of whose bonds to buy. A massive bond market intervention could lower borrowing costs - but most companies in Europe get credit from banks, not bond sales.

Keep Talk

At his news conference Draghi may hold the door open for more stimulus measures down the road if they're needed - especially if the bank stops short of measures beyond a rate cut. Much may then depend on how convincing he is.