ECB Cuts Rates as the Eurozone Flirts With Deflation

The European Central Bank’s (ECB) surprise rate cut Thursday and its new plan to buy euro-denominated bonds and asset-backed securities was just the shot moribund European markets needed — at least for now.


Benchmark indices in the U.K. and Germany rose anywhere from 0.25% to 0.5% on the rate cut, while France and Spain leaped by more than 1%.

Predictably, the euro tumbled to a 14-month low against the dollar. True, that’s bad news for U.S. companies that derive revenue from Europe. A stronger dollar is going to make their goods more expensive. In addition to the drag on demand a stronger dollar has, it also hurts the top line when sales in euros are converted into greenbacks.

It is, however, preferable to the alternative. Although U.S. companies and investors won’t like what unfavorable foreign currency exchange does to corporate revenue, it’s a far sight better than what another eurozone recession would do to demand. A plunging euro is a small price to pay if it helps restart growth in the eurozone.

Whether the ECB’s latest stimulus measures can shake the eurozone of its funk very much remains to be seen. Rate cuts and lower interest rates across the yield curve might spark demand for credit and even juice spending, but they can’t undo the damage done by the conflict with Russia.

It’s also unclear if it will be enough to get inflation anywhere near the ECB’s target of 2%. Led by energy price weakness, eurozone inflation is projected to come in at just o.6% this year — far too close to being deflationary for comfort.

ECB Rate Cuts to Head Off Deflation

Although the timing of the ECB rate cut was surprising, that it happened at all is a no-brainer. The eurozone recovery is faltering, and badly. GDP stalled out for the eurozone as a whole in the most recent quarter. France’s economy remained flat, while Italy and Germany actually contracted.

The current quarter is looking soft for the economies of Europe as well, and perniciously low inflation is both a symptom of economic malaise and a cause. There’s no rush to spend money today if prices will be the same — or lower — tomorrow. Indeed, consumer prices in Spain actually declined last month.

Meanwhile, the struggling economies of Southern Europe need to maintain rates of inflation below that of Germany in order to make their prices competitive. With German inflation running at just 0.8%, it forces those Southern economies to drop prices dangerously close to deflationary levels.

Higher inflation isn’t necessary for recovery — just look at the U.S. — but it does help head off deflation and recession. After all, the European recovery barely got going in the first place. Now Germany is slowing and France and Italy never really entered recovery mode. The crisis with Russia is only piling on to the region’s economic woes.

Given the troubles, it comes as no surprise that the ECB would follow in the footsteps of the U.S. Federal Reserve, dropping short-term interest rates to their lowest possible level and dipping into the bond market to suppress the long-end of the yield curve too.

The real head-scratcher is … what took the ECB so long?

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