ECB Acts

By Eoin Fahy, Thursday, 3rd November 2011 | 0 comments

The European Central Bank has just announced that it is to cut its key interest rate by one quarter of one percent, taking the rate to 1.25%, and left the door open to future cuts in the months ahead.  This was an unexpected decision, at least with regard to its timing, and will provide some modest help to the eurozone economy.  However the crisis has reached such proportions that a mere 0.25% cut in interest rates certainly does not represent a dramatic step.  Greece remains the centre of attention.

Going in to today's meeting of the ECB's governing council, very few analysts expected a cut in interest rates.  This was mainly because it was the first meeting presided over by Mario Draghi, the very new head of the ECB, and it was thought unlikely that he would like to take such a significant decision at his first meeting. There was also a sense that the ECB would not like to be seen to be panicking and reacting to this week's events in a knee-jerk manner.

With hindsight, perhaps it was surprising that expectations of a cut were not higher.  After all, the eurozone economy already seems to be moving towards recession, if it isn't already in one, and of course there is a severe fiscal, political and indeed constitutional crisis across the eurozone which is obviously affecting business and consumer confidence.  These are exactly the conditions in which a central bank might be expected to cut interest rates, notwithstanding the fact that current inflation is somewhat higher than targeted.  After all, a central bank should set interest rates in line with expectations of where inflation is going in the future, not in line with where inflation is today.

So what impact will this rate cut have?  Unfortunately the impact will be very limited indeed.  Firstly the change is very small, at just 0.25%.  For a loan of €100,000, the reduction in interest payments would amount to only €250 per year, or a little more than €20 per month, which is certainly not enough to make a significant difference to any household or small business.  But in addition, with banks under pressure to rebuild margins and increase profitability (or reduce losses), it's likely that the rate cut will not be passed on in full, or perhaps at all, to borrowers.

There could of course be some indirect benefits. The fact that the ECB is at last cutting its interest rate might help to boost confidence and so boost consumer or business spending, even in the actual direct financial impact is very small.  Or, in theory, lower euro interest rates might cause the euro to decline, which would boost exports.  But the boost to confidence will surely be totally overpowered by the knock to confidence arising from this week's twists and turns in the  the ongoing eurozone fiscal mess (sorry, crisis), and the fall in the euro after the announcement was less than one percent, definitely not enough to make a significant difference to competitiveness.

All in all then, while the rate cut is welcome, and is better than nothing, the real focus will remain on events in Athens and Cannes (where the G20 leaders are meeting), and not on the ECB's headquarters in Frankfurt.  Some day the ECB will, in our view, be forced into dramatic action to save the euro.  But not today!

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