ECB Cuts Key Rate to 1.25%: is it Enough?

In Financials, Politics on April 2, 2009 at 13:18

jean-claude-trichetThe European Central Bank officials cut the key interest rate today by 25 basis points to a new low of 1.25% which was, still, much less than expected by market analysts. This resulted in upward pressures for the euro against other major currencies. Analysts suggest that ECB’s decision to maintain the rate above 1% levels is due to the consensus of optimism in the G20 summit and the feeling that markets have already reached bottom and the road to recovery is straight ahead of us.

Moreover, the ECB has cut its discount or else ‘facility rate’ – overnight rate at which the ECB lends money directly to banks – to 0.25% from 0.50%, opening the road for the Central Bank to flood money into the economy through the process of ‘Open Market Purchase’ known as ‘Quantitative Easing’ which would have the ECB to buy corporate debt.

The more the ECB rates approach to ‘zero-rates’ territory, the more hesitant its officials get. Eurozone inflation is now at 0.6%, which is well below ECB’s target which is “close to, but below” 2%, and is likely to turn negative in the coming months. Jean-Claude Trichet, ECB’s president, claims that zero rates will create “damaging economic distortions” and trigger extreme inflationary pressures in the next two years.

Now, do Mr. Trichet’s policies fall behind the curve? Most people say yes and I am one of them; banks will be unwilling to borrow funds presuming the ‘cutting-rates’ cycle hasn’t reached an end yet, anticipating for even lower rates. In other words, the ECB is only postponing higher lending and this reactive stance may disco-ordinate markets and drag the European economy into a deeper recession.

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