Credence Independent Advisors Blog

Expectations are running high that the European Central Bank (ECB) will loosen its monetary policy at its meeting on Thursday.

Most expect at least a cut to the benchmark interest rate, while others say the ECB will go further.

It is thought the ECB could introduce negative rates on deposits, in an effort to boost bank lending.

This would mean banks would pay to keep money at the central bank, rather than receiving interest.

Recent economic indicators show that the recovery in the eurozone is subdued at best.

On Tuesday, figures showed that inflation fell to 0.5% in May, considerably below the ECB’s goal of just below 2%.

This has raised the threat of deflation, in which growth essentially grinds to a halt because consumers put off spending in the belief that prices will fall further. Likewise, investors stop investing.

Unemployment continues to plague the eurozone. On Tuesday, a report showed that the rate for the bloc as a whole fell to 11.7% in April from 11.8% in March.

But many embattled economies of the eurozone still suffer with much higher rates – for example, Spain has an unemployment rate of 25.1%, while Greece’s is 26.5%.

Fighting talk

So, on Thursday, analysts say the ECB will come out fighting.

Howard Archer, the chief economist at IHS Global Insight, said: “The ECB hardly needs any more reason to deliver a major package of simulative measures at its June policy meeting on Thursday to counter the risk of prolonged very low inflation turning into deflation.”

At 0.25%, the benchmark interest rate is already low. But some economists feel the ECB will cut it again, possibly to 0.1%.

Monetary arsenal

The ECB could also use further weapons.

Even though interest rates are low, the commercial banks are still reluctant to pass them on to their customers, mainly because they remain cautious about lending.

As such, the ECB could slash the rate it pays on deposits from the banks to below zero.

That in effect means the banks pay the ECB for keeping their money, creating an incentive for the banks to lend that money elsewhere – ideally to businesses, so that growth can be boosted.

Christian Schulz at Berenberg Bank said that that, as well as a reduction in the benchmark interest rate, could prove to be a powerful cocktail that would boost bank lending.

“But negative deposit rates have not been used at this scale before and could have unpredictable consequences,” he added.

“Unchartered waters”

Leaning hard on the eurozone’s banks to get them to lend to businesses has not been a priority for the ECB in the past. In the summer of 2012, ECB president Mario Draghi felt that measures such as negative deposit rates were “largely unchartered waters”.

But for many analysts, it seems the continuing storm of economic crisis in the eurozone is now blowing the ECB ship into just such territory.