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Although the ECB didn’t announce any radical new action yesterday, it did take a number of steps that are significant moves for a traditionally cautious and conservative policymaker.
First of all, the main refinancing rate was cut to a new record low level of 75 basis points.
Second, the ECB matched the 25 basis point cut in its refinancing rate with a 25 basis point cut in its deposit rate that took the latter to zero.
The ECB has usually altered this policy rates by the same amount but attention has tended to focus only on the refinancing rate because it is normally the key policy rate determining interbank money market rates. Since EMU began in 1999, market rates tended to set close to the ECB refinancing rate and normally some distance away from both the upper boundary set by the marginal lending rate or the lower boundary set by the ECB’s deposit rate.
In the past couple of years, however, major injections of liquidity by the ECB and market expectations that policy would remain accommodative and/or be eased further have meant that interbank rates drifted below the refinancing rate towards the ECB’s deposit rate. Given the increasing amount of funds deposited at the ECB it is scarcely surprising that the ECB deposit rate has become an increasingly important floor to market rates.
Yesterday's ECB decision to take its deposit rate and, by extension, the floor to market interest rates to zero is something of a step into the unknown. As a speech by ECB Executive Board Member Benoît Cœuré (19th February 2012) noted ‘a switch to zero or negative interest rates bears some risks – mainly of a microeconomic nature – which would have to be weighed against potential benefits in terms of additional macroeconomic stimuli.’ Mr. Cœuré cited a possible drop in money market turnover, an adverse impact on important market intermediaries, such as money market funds and possible adverse effects on the profitability of commercial banks that could result in a credit contraction. Mr. Draghi was reluctant to be drawn on the possible consequences of a zero deposit rate at today’s press conference but it would seem the ECB Governing Council has judged that any risks would be outweighed by the benefits of lower money market rates in channeling investors away from less risky assets.
The decisions on Thursday to cut the refinancing rate to a record low and to reduce the deposit rate to zero only partly reflect the extreme weakness of the Eurozone economy. They also stem from a need to respond to major problems in the functioning of the Euro area money market that is further weakening the economic outlook. Transactions in the Euro area money market have become increasingly fragmented along lines largely determined by national boundaries. Interbank activity has also reduced sharply in terms of the volume and maturity length of transactions. As a result, changes in ECB policy rates don’t immediately or automatically flow through to bank funding costs nor consequently to the real economy. Commercial banks will benefit to the extent that they fund themselves through the ECB’s refinancing operations. However, in circumstances where the interbank ‘plumbing’ isn’t operating properly adjusting the policy thermostat by cutting official rates may not prompt an immediate and equal change in borrowing costs for financial institutions and their customers.