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Draghi’s low inter rate pledge

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Draghi’s low inter rate pledge

The European Central Bank cut its benchmark lending rate to 0.25 percent in an effort to combat the slowest pace of inflation growth in four years. Policymakers weighed the threat of deflation against the central bank’s mission of price stability, leading to a decision that only three of 70 economists predicted, according to a recent Bloomberg survey. A growing contingency of market participants believed another rate cut may soon be on the horizon, but very few expected the decision to come so soon.

ECB President Mario Draghi has already pledged to keep rates at record lows. However, given the weakening pricing power in the 17-nation currency bloc, market participants are speculating whether the central bank president will pursue more drastic measures, such as quantitative easing or a negative deposit rate, to invigorate growth. As inflation continues to fall short of the 2 percent target, looser monetary policy will remain the norm.

Central bank speculation ushered a mass sell-off of the euro, which hit six-week lows against the US safe haven last week. The ECB’s willingness to tender lower interest rates, combined with unexpected growth in the US manufacturing industry, could tip the scale in favour of the greenback over the next several weeks. A depreciation of the euro could help Eurozone exports, which have been restrained by high exchange rates. The euro has been well-supported since March on growth prospects and expectations for a shift in US monetary policy.

Prior to the latest rate cut, the ECB had kept its lending rate unchanged since May. In the summer central bank officials promised to keep interest rates at record lows “for an extended period of time” in order to keep the lending environment favourable. Draghi has played his part by promising to use “any instrument, including another LTRO [long-term refinancing operation]” to keep lending rates low. Unlike other central banks, the ECB has mostly refrained from large-scale market operations, like the ones currently in-use by the US Federal Reserve and Bank of Japan.

Whether the risk of deflation will spur more drastic action on the part of the ECB is yet to be determined. If central bank officials believe the euro area is at risk of falling into deflation or stagnation, the latest rate cut could be the first of many policy instruments to be exploited.

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