QNB Group: ECB Monetary Stimulus May Avoid Eurozone Deflation

Doha, June 14 (QNA) – The European Central Bank (ECB) monetary stimulus may avoid Eurozone deflation, said Qatar National Bank (QNB) in its weekly analysis on Saturday.

The European Central Bank (ECB) announced a package of monetary stimulus measures on Thursday, June 5. The package includes lowering the deposit rate to -0.1% the first time that the ECB will charge commercial banks for depositing excess reserves at the central bank. It also included a new program to provide banks with cheap funding to encourage lending to the real economy. The aim is to provide a monetary stimulus to avoid deflation within the Eurozone. These new measures are important to prevent deflation but more may need to be done if the current trends of negative foreign inflation and weak domestic demand continue. The new policies are likely to reduce the spreads between Italian, Greek, Portuguese and Spanish bond yields (the so-called periphery) and those on German bunds, while the Euro is likely to weaken if the inflation outlook improves.

Unlike earlier ECB measures which aimed at saving the Euro, the ECB approved this package on June 5 because of the deterioration in the economic outlook, especially in the form of low inflation. Eurozone inflation has been steadily declining, falling to 0.5% in May, well beneath the ECB target of below, but close to, 2%. Moreover, the outlook for inflation is worsening: the ECB has revised down its forecast for 2014 inflation to 0.7% and expects low inflation to persist over the medium term. This risks re-enforcing the state of low inflation or possibly even deflation. Absent proactive monetary intervention, the Eurozone is at risk of turning into Japan with a prolonged period of deflation and slow growth, made worse by a declining population. The threat of Japanification prompted the ECB Governing Council to act decisively and, significantly, in a unanimous manner.

The most headline-grabbing measure was the lowering of the interest rate corridor leading to a negative deposit rate. The ECB is hoping that, by charging banks for depositing their excess reserves at the ECB, they would have a strong incentive to lend more money to the real economy. While setting negative interest rates is an unprecedented step for a major central bank (Denmark and Sweden have recently had negative rates with no major impact on the domestic economy), this may not be the most significant measure taken by the ECB. Excess reserves have been trending downwards as banks have been repaying their borrowings from previous ECB long-term refinancing operations. Furthermore, there is little scope for decreasing the rates further with Mario Draghi, the President of the ECB, clearly stating that “for all the practical purposes, we have reached the lower bound.” However, it does signal intent of the ECB to pursue unconventional monetary policies. (MORE)

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