Here’s Why the ECB Cut Interest Rates to New Historic Lows

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In a surprise move, the European Central Bank cut its main rate from 0.5 percent to 0.25 percent, The New York Times reports.

In a development largely unexpected by economists, the ECB decided to slash its primary interest rate to a new historic low at its monthly meeting. While some analysts had expected the bank to take action in the wake of lukewarm economic data, few, if any, had expected the bank to take so drastic a measure at this point in time, with most arguing that the bank would at least wait until December before considering a primary rate cut, according to the Times.

Also cut was the emergency borrowing rate, Reuters reports, which was moved to 0.75 percent from 1 percent at the meeting.

The move is likely a reaction to the perceived threat of deflationary pressures. With inflation in the eurozone sinking to 0.7 percent in October, fears had arisen over the consequences of having an inflation rate far below the central bank’s official target, which is at just below 2 percent. When rates come close to deflationary levels, it becomes more worthwhile for consumers and businesses to hold onto cash, stifling activity levels throughout the economy.

However, there is likely to be some disagreement over whether October’s inflation data really warranted such an enormous step. Among the most probable opponents are the Germans, who have said that the inflation rate was actually driven by factors such as downward pressure on wages in Spain and Italy, and a drop in energy prices.

Many Europeans will be supporters of the move, as it is good news for exporters. The euro dropped sharply in response to the news; when the euro is weak, exporters are better off, as obtaining a certain amount of money for a product translates into more euros for the exporter. With economies such as Spain trying to use export-based strategies to support their economic turnarounds, having a weaker euro is actually beneficial to such economies.

Another problem that Mario Draghi, the chief of the ECB, is trying to fix with the move is a lack of liquidity in the eurozone. By lowering the interest rate, banks will be more likely to obtain funds and then pass the funds on to businesses in the form of loans. Though this is fine in theory, it has the side effect of making borrowing to purchase government debt a more attractive option, as well.

Today’s decision signals more than ever that Draghi intends the ECB to be at its most active levels in the history of the organization. By taking a proactive stance, the bank is hoping to fend off fears that the region’s economies may fall into stagnation in the wake of one of the hardest recessions in modern times. However, the bank is beginning to back itself into a corner, as it is leaving itself less room to maneuver if conditions fail to improve in the coming months.

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