Here’s How the ECB May Respond to Low Inflation Rates

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Low inflation rates in the month of October pose a fresh set of problems for the European Central Bank, the Associated Press reports.

In October, inflation rates in the eurozone were just 0.7 percent. That represents a decline from September’s 1.1 percent value, and it puts rates significantly below the ECB’s target of slightly under 2 percent. The decline was driven primarily by significant deflation in energy prices as well as a drop in inflation in the food, alcohol, and tobacco sectors.

Inflation rates that are too low can present a serious roadblock to an economic recovery for European economies. When inflation is low — or if deflation were to set it — people are encouraged to hold onto cash rather than make purchases. This, in turn, slows the numbers of transactions in an economy, leading to depressed conditions for businesses and, ultimately, lower economic growth.

While most economists are united in expressing concern over the low inflation rates, members of the ECB are at odds over how to go about countering the trend. One option could be to establish a third so-called Long-Term Lending Operation, or LTRO, to introduce more funds into the market.

This would have positive side effects such as fighting the rise in the euro (several days ago, it stood at a two-year high) and increasing liquidity ratios across the region. Having more money in the system theoretically makes it easier for businesses to acquire access to capital, though in practice it may just lead to banks acquiring a greater amount of government debt.

Another option is for the ECB to further lower interest rates. The bank’s benchmark rate currently sits at 0.5 percent, a historic low, but an additional cut is not totally out of the question. Again, this would in theory encourage economic activity and access to capital. However, it also has the side effect of making government debt more attractive to banks because they would have access to cheaper funds, as well.

A final option for the ECB is to do nothing — or, at least, close to nothing. This could include trying to talk down market rates and talk up inflation, something that has so far garnered mixed success for Mario Draghi, the bank’s head. Other options could include lowering the bank’s deposit rate below zero percent or halting the collection of certain accounts from banks, which was originally instituted to offset the money injected into the region through bond-buying programs.

Either way, the European Central Bank faces a daunting set of problems moving into 2014.

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