Central banks act when expectations miss to the downside; today was the rule and not the exception. The European Central Bank (ECB) cut interest rates, notably lowering the interest rate on the deposit facility into the negative territory of -0.10%. The ECB’s response to very low price growth is too little too late, but it sends an important message to markets that Europe’s head economists understand the eurozone’s downside risks and are willing to act against them, at least marginally. Europe’s growth will not be improved as a result of today’s action, but the ECB has helped the economy dodge the vicious market correction that inaction would have prompted.

Considering the practical effects of negative interest rates, banks effectively will be charged for any reserve cash they hold over reserve requirements. A reduction of interest rates for banks doesn’t necessarily translate into a reduction of rates for Europe’s business and household savers ─ that’s a decision that banks make on an individual basis and concerns their own margins ─ but sustained low profits make it likely that banks will carry the cut over to their business and consumer customers.

Lower rates, and even negative rates, will not spur banks to lend, which would provide the much-needed boost for European business which relies heavily on bank lending for their corporate financing. Near-zero rates for years have not improved lending activity, and European bank stress tests will discourage banks from shedding any capital from their balance sheets. Perhaps more importantly, demand for loans will not improve as a result of these measures, nor will banks suddenly decide to trust businesses and households.

Lending is contracting at the fastest rate since the crisis as of Q4 2013
(Loans to non-financial businesses and households, %YOY)

The ECB assuredly recognizes this shortcoming, and thus announced its intent to intensify the preparatory work related to outright purchases of asset-backed securities (ABS). In other words, quantitative easing (QE) is still on the table for the next meeting on July 3. Although it is not yet clear what assets the ECB can buy within its mandate, quantitative easing would be a large step toward boosting the European economy, reducing the value of an overpriced euro and encouraging export growth in most European markets, creating jobs and reducing inflationary risk.

In the meantime, the ECB’s rate cut will serve only as a market signal. The central bank cannot yet engage the highly politicized QE, but knows that markets would lash back at inaction in light of prolonged low inflation. FSG’s base case for growth in Europe thus remains intact: the region will see very low growth in the long term, which will separate outperforming companies from their peers similar to the Japanese experience of the “lost decade”. FSG clients may use the new Western Europe Regional Outlook, to be released June 9, to outline specific opportunities for growth in a low inflation environment.