ECB Cuts Key Eurozone Interest Rate to Record Low of 0.75%

As largely expected, the European Central Bank (ECB) cut its key interest rate from 1.00% to a record low of 0.75% at its 5 July meeting. The ECB had previously cut interest rates by 25 basis points in both December (from 1.25% to 1.00%) and November 2011 (from 1.50% to 1.25%). These interest-rate cuts at the end of 2011 were taken in reaction to the deteriorating Eurozone economic situation and serious risk of recession. They marked a quick, full turnaround in the Eurozone interest-rate cycle, as the ECB had previously raised interest rates to 1.50% from 1.25% in July 2011 and to 1.25% from 1.00% in April the same year. Prior to the April 2011 hike, the ECB's key interest rate had stood at 1.00% (the then lowest level since the Eurozone came into being in January 1999) since May 2009.

The ECB also cut its deposit rate to 0.00% from 0.25% at its July meeting. This acts as the floor for money-market rates, and by cutting it to 0.00% the ECB is most likely hoping that it will encourage banks to lend more to each other, and to the private sector, rather than just park the money with the ECB.

The ECB's decision to cut its key interest rate to 0.75% can be seen as a significant change of tack as the bank notably did not take interest rates below 1.00% even at the height of the 2008/09 recession. Indeed, this had led to a belief that there was a significant core of ECB Governing Council members who had a strong aversion to taking interest rates below 1.00%. However, the ECB has come across as more flexible and pragmatic in its policy-making since Mario Draghi replaced Jean-Claude Trichet as president in November 2011, although many of the Governing Council members are the same as in 2008/09.

There had been indications at the June ECB policy meeting that the bank was moving towards cutting interest rates. Most significantly, Draghi had indicated that the decision to keep interest rates at 1.00% in June was by consensus, albeit "broad". He also stated that "a few" Governing Council members favoured an interest-rate cut then. In marked contrast, Draghi had indicated at both the May and April ECB meetings that there had been no discussion about cutting interest rates.

July ECB Decisions Unanimous

Draghi reported that the ECB's interest-rate cut decisions in July were all unanimous—not just the decision to reduce interest rates but also the size of the cut. The ECB indicated that the decision to cut rates in July was significantly influenced by not only a renewed weakening in Eurozone activity in the second quarter and heightened uncertainty, but also by signs that the weakening in activity has become more widespread across countries recently. Although the ECB expects Eurozone economic activity to recover gradually over the coming months, it acknowledges that this recovery will be limited by a number of factors, notably including ongoing sovereign debt tensions, tight credit conditions, high unemployment, and the need for deleveraging in both financial and non-financial sectors. Furthermore, the ECB sees the risks to the growth outlook as slanted to the downside.

Meanwhile, the ECB sees the inflation outlook as relatively benign. Eurozone consumer price inflation came down to 2.4% in May and June from a peak of 3.0% in late 2011, and the ECB sees it falling further over the rest of 2012 and moving below 2.0% in 2013. In fact, Draghi indicated that the ECB believes Eurozone consumer price inflation could possibly move below 2.0% before the end of 2012. The ECB sees the risks to these inflation forecasts as "broadly balanced" and considers inflation expectations to be "firmly anchored".

Although the ECB cut interest rates at its July meeting, it gave no indication that it was inclined to take any further non-standard measures, such as offering another unlimited three-year refinancing operation. It also gave no indication that it could revive its bond-buying programme, which has been dormant since April.

Outlook and Implications

IHS Global Insight expects the ECB to keep interest rates at 0.75% throughout the rest of 2012 and the first half of 2013, although we believe the bank should be prepared to take rates lower if there is no improvement in the Eurozone's economic situation and outlook. Although Eurozone GDP stabilised quarter-on-quarter in the first quarter of 2012, this was highly dependent on reasonable growth in Germany. Furthermore, latest survey evidence indicates that it is highly likely that renewed, appreciable Eurozone GDP contraction occurred in the second quarter. The Eurozone is being buffeted by major headwinds, notably including increased fiscal tightening in many countries, markedly rising unemployment, and tight credit conditions. Consumers are under additional pressure from muted wage growth and, in some countries, a need to deleverage. On top of this, relatively muted global growth is limiting export orders.

Meanwhile, the Eurozone sovereign debt crisis is still highly problematical despite the relatively favourable Greek election result in mid-June and some encouraging steps taken at the EU leaders' summit in late June to ease pressure on Spanish and Italian funding costs and move towards greater banking integration. Consequently, uncertainty remains high, which is likely to cause businesses to limit their investment and consumers to hold back on their spending. Although we expect Eurozone economic activity to stabilise during the final months of 2012, this is far from certain, with much depending on a sustained easing of Eurozone sovereign debt tensions.

Importantly for the ECB, the Eurozone inflation situation and outlook is looking increasingly benign. Whereas Eurozone consumer price inflation had been locked in a range of 2.6–2.7% during the first four months of 2012, it fell to 2.4% in June and should eventually come down appreciably further. Encouragingly, oil prices have recently fallen back markedly and even hit an 18-month low under USD90/barrel in June. Critically, there are important indications that underlying inflationary pressures will be limited going forward. For example, the European Commission's business and consumer confidence survey shows that consumers' inflation expectations have trended downwards so far in 2012 and were actually below long-term norms in June. Furthermore, any renewed spike in consumer inflation expectations would be unlikely to fuel markedly higher wage growth in most countries given persistently high and now generally rising unemployment. Therefore, it remains unlikely that a damaging upward wage-price spiral will develop.

Significantly, companies' pricing power appears to be waning. The composite output prices index of the manufacturing and services purchasing managers' surveys indicated that prices fell for a third month running in June, and at the fastest rate since February 2010. Meanwhile, the European Commission survey showed that pricing expectations among manufacturers, service companies, and retailers retreated markedly for a third month running in June. Further supporting the view that underlying price pressures will be limited, the adjusted three-month moving-average growth rate for annual Eurozone M3 money supply was limited to 2.8% in May, well below the ECB's targeted rate of 4.5%. Consequently, the chances seem high that core Eurozone inflation will be relatively modest over the medium term, and it remains probable that Eurozone consumer price inflation will fall back in line with the ECB's target rate by the end of 2012.

Further ahead, we believe that the ECB will have a crucial role to play in Eurozone policy-makers' efforts to contain the fall-out from an expected Greek exit from the Eurozone around mid-2013. ECB action could well include: providing substantial liquidity to banks; stepping up its own bond-buying activity, effectively setting a cap on bond yields of Spain, Italy, and other vulnerable countries; and providing assistance in recapitalising Eurozone banks. We also expect the ECB to trim interest rates further, taking them down to at least 0.50%. In addition, the EU summit in late June agreed that the ECB will be given a supervisory role for Eurozone banks in 2013.