ECB Cuts Main Rate on Deflation Concerns, but Effect on Corporates Expected to Be Negligible

The European Central Bank (ECB) made a surprise cut to its benchmark interest rate last week, reducing the 0.5% main rate, which was already at a record low, by another 25 basis points to 0.25%.

The move arrives on the heels of diminishing inflation in the euro zone. In October, inflation fell to an annual rate of 0.7%, whereas the ECB has aimed to keep inflation at 2%. While lower inflation might not sound like such a bad thing, especially for cash-poor consumers, October's decline could suggest a greater risk of deflation, which some say poses a greater threat.

"In the euro zone as a whole, sovereigns, banks and households are still heavily indebted, which means that deflation poses a higher risk to recovery than inflation," said AIG Chief Country Risk Economist Carolyne Spackman. "When consumers expect falling prices, they tend to hold off discretionary purchases, which erodes corporate profits and puts downward pressure on both wages and government revenues. Deflation is pernicious in that it makes it even harder for debtors to service their debts, and it can also trigger the need to post additional collateral against secured loans."

In announcing the decision, ECB President Mario Draghi noted that the rate cut aligned with the Bank's prior guidance regarding inflation, but warned that low inflation could be a lasting issue. "We may experience a prolonged period of low inflation, to be followed by a gradual upward movement towards inflation rates below, but close to, 2% later on," he said. "Accordingly, our monetary policy stance will remain accommodative for as long as necessary. It will thereby also continue to assist the gradual economic recovery as reflected in confidence indicators up to October."

Spackman agreed that the response of Draghi and his cohorts suited the severity of the deflation threat. "Easing monetary policy is appropriate to prevent deflation from setting in, and this helps to understand why the ECB cut interest rates after inflation was only 0.7% in October," she said, "but with the re-fi rate at 0.25%, there is little further room to cut, especially as the deposit rate is already 0%."

While some of the latest news from the euro zone has given some analysts reason for optimism, particularly Germany's manufacturing numbers and Spain's outlook upgrade, the ECB's future efforts to stimulate the economy will almost have to focus on extending liquidity to banks rather than cutting rates any further. Still, whatever steps Draghi chooses to take in 2014 and beyond, the results might not trickle down to non-financial companies. "Banks are still focused on balance sheet repair, and the increased liquidity may not be transmitted to firms," Spackman said. "The rate cut will do little to stimulate lending, and as long as this trend continues, it means that credit managers have to be vigilant, because customers in the euro zone may continue to have difficulty accessing credit."

- Jacob Barron, CICP, NACM staff writer

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