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ECB prepares QE

August 7, 2014

The European Central Bank (ECB) has said it will keep interest rates at low levels for much longer as the eurozone recovery is facing mounting risks - and is weighing asset purchases to avert the threat of deflation.

Mario Draghi EZB Sitzung am 03.07.2014
Image: Reuters

Following a meeting of its rate-setting Governing Council on Thursday, the European Central Bank (ECB) said its interest rates would remain at historically low levels "for an extended period of time."

In June, the ECB cut its benchmark refinancing rate to a record low of 0.15 percent and its deposit rate for commercial banks to minus 0.10 percent, effectively punishing banks for hoarding funds with the ECB rather than lending them to the real economy.

"Heightened geopolitical risks, as well as developments in emerging market economies, may have the potential to affect economic conditions negatively," ECB President Mario Draghi told a news conference in Frankfurt.

Latest ECB data suggest that the eurozone's recent recovery from a protracted recession is faltering. While the Spanish economy grew by a solid 0.5 percent in the second quarter, Italy slipped back into recession. Belgium also suffered a sharp slowdown, and the German economy - Europe's engine of growth this year - seems headed for stagnation in the quarter.

Bond-buying program on ECB agenda

As a result, Draghi said that the central bank was "unanimously committed" to use more "unconventional" monetary policies to shore up economies. The ECB, he added, was undertaking "intense preparatory work" for the launch of asset purchases under a quantitative easing program.

Quantitative easing (QE) has been used by the US central bank (US Fed) to provide commercial banks with fresh liquidity in exchange for collateral such as government bonds, private loans and other assets. In the eurozone, the policy is controversial because critics say it amounts to direct funding for cash-strapped states from the central bank, which is not allowed under ECB rules.

Deflation - When Everything Gets Cheaper!

The ECB, however, aims to use QE to fight low inflation and spur lending, especially in the credit-starved southern periphery of the eurozone. In July, annual inflation in the currency area fell to an all-time low of 0.4 percent, well below the ECB's target of 2 percent.

If prices actually begin declining - a phenomenon known as deflation, the opposite of inflation - a dangerous spiral of negative economic dynamics could result, with consumers deferring purchases in expectation of still lower prices to come, resulting in an economic slowdown and job losses that further depress wages and hence prices, in turn causing more deflation, as desperate businesses compete for fewer customers. Central banks see mild deflation as much more dangerous than mild inflation.

Quantitative easing is widely regarded as the ECB's last instrument in its tool box of anti-deflation monetary measures.

uhe/nz (dpa, Reuters)