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Will negative interest rates help the Eurozone avoid deflation?

Chris Scott examines the potential effects of the ECB's historic decision to implement a negative rate of interest across the Eurozone

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Photo credit: JT
Photo credit: JT

The experiences of Japan in the 1990s may have seemed a far cry from conditions in the Eurozone prior to the financial crisis. However since then concerns of Japanese-style deflation harming economic recovery led Mario Draghi, leader of the European Central Bank, to announce the introduction of negative interest rates. Draghi's intervention marks the latest in the past several years, when it has seemed that the Eurozone's fragile economic recovery may be at risk.

The negative rate imposed will lead to a 0.1% charge on bank deposits placed at the ECB. This is intended to stimulate bank lending now, and as such to increase consumer and business activity. Further to this in order to try and increase demand in the Eurozone periphery the ECB has set up a scheme to make cheap loans to businesses, worth up to EUR400 billion.

The announcements follow the ECB cutting growth forecasts across the Eurozone, with expected growth of 1% per annum and a corresponding inflation figure of 0.7% in 2014. The target inflation rate for the Eurozone is 2%, with a figure below this signalling the expectation of consumers that their incomes are unlikely to rise in the future. This has largely been driven by a significant drop in demand, which for the Eurozone as a whole remains 5% lower than in the first quarter of 2008.

The policy measures have since faced some criticism for failing to be bolder in tackling the crisis. In particular economists have suggested that a 0.1% cut is not large enough for banks to factor into decision making when deciding whether or not to lend. By contrast others have hailed the measures as igniting 'monetary policy fireworks' and praised the ECB's boldness in being the first major central bank to implement negative interest rates on deposits.

The ECB also reaffirmed its commitment for not directly purchasing government bonds from Eurozone member states. This approach has been used by America and Japan since the start of the crisis, and has helped to expand the money supply and reduce long-term interest rates. Newspapers such as the Economist have also suggested that this could be the best way for the Eurozone to avert deflationary pressures. However this is still not considered politically viable for Europe, due to objections from Germany that it would undermine long-term price stability.

As such Mario Draghi's latest announcement should be viewed as a realistic set of policies to try and address sluggish demand in the Eurozone. It remains true that a lower negative interest rate might have had a greater impact on the decision making of banks, therefore doing more to stimulate lending. However the policies do mark a continuation of the ECB's commitment to ensure the recovery of the Eurozone. This credibility was reaffirmed in light of the announcement, in which the bond yields on 10 year bonds issued by countries such as Italy, Spain and Greece fell to record lows.

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