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Like a falling stone

5 September 2014 By Swaha Pattanaik

Euro zone inflation is too low, and economic activity sluggish. But at least one thing is going the European Central Bank’s way. Its hankering for a weaker currency will be fully gratified.

The euro dropped sharply after the ECB slashed interest rates on Sept. 4. It cut its main rate to 0.05 percent and lowered its deposit rate to minus 0.20 percent. It also announced a significant asset-buying programme, to start in October. The single currency’s fall to 14-month lows, below $1.30, was its biggest one-day decline since November 2011. A broad trade-weighted measure of its value also hit its weakest in more than a year, after falling 4.3 percent since March.

That is just what the ECB wants. A weaker euro will lift inflation – the central bank’s current priority. Austrian central bank governor Ewald Nowotny acknowledged in an interview that rates were cut partly to help weaken the euro, and that an exchange rate around $1.30 or slightly lower was “going in the right direction.” More of the same would clearly be welcome in Frankfurt.

Traders will oblige. They know how painful it can be to flout the central bank’s wishes. Since the ECB initiated negative deposit rates – the floor for euro zone money market rates – in June, the average overnight bank-to-bank lending rate has also turned negative. This means some banks are paying to lend euros to others. They will soon pay even more for the privilege, given that the latest rate cut will further depress interbank rates. That is even before the ECB pumps more liquidity into the system.

Nor will the low-rate environment change anytime soon. Without the impact of this week’s measures, ECB economists forecast inflation at just 0.6 percent this year and 1.1 percent in 2015, way below the central bank’s near-2 percent target. They also forecast subdued GDP growth – just 0.9 percent in 2014, and 1.6 percent in 2015.

Currency traders have sometimes tried to defy the Group of Seven leading industrial nations in the past. But with the cruel and unusual punishment of negative rates, the ECB holds sway.

 

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