Euro weakens as ECB member says negative rates are an option

The euro fell to a two-month low against the yen and European government bonds strengthened yesterday, amid renewed expectation that the European Central Bank will implement stimulus measures at its next rate-setting meeting in June, including a cut in interest rates.

ECB executive board member Peter Praet told German newspaper Die Zeit that negative deposit rates was one of a number of measures being considered by the bank.

“Negative deposit rates are a possible part of a combination of measures,” the ECB chief economist told the paper. “We are preparing a number of things,” he added, including interest rate cuts or a long-term refinancing operation.

Reuters reported a cut in interest rate was “more or less a done deal”, citing five sources familiar with the matter.

Following its May governing council meeting last week, ECB president Mario Draghi said the council was "comfortable" with taking action next month.

The bank is understood to be considering a possible cut to all three interest rates, bringing the deposit rate into negative territory for the first time, a move that would be likely to affect exchange rates. The ECB has been criticised, particularly by France, for not tackling the strengthening euro.

Politicisation
In an indication of the politicisation of the issue, the European People's Party candidate for European Commission president and former euro group president Jean Claude Juncker, told journalists in Paris yesterday he would consider proposing binding foreign exchange policy guidelines for the ECB, should he replace José Manuel Barroso as commission president after next week's elections.

An interest rate cut to banks’ overnight deposits could also encourage banks to lend more.

In addition to interest rate cuts, the ECB is likely to unveil a new long-term refinancing operation programme – whereby the ECB provides finance to euro zone banks – which would come with the condition that banks borrowing from the ECB must increase lending to smaller businesses. As an alternative to the long-term refinancing programme, the ECB could also announce an asset-backed securities purchase plan that would see the ECB buy bundled packages of SME loans.

With the rate on deposits now at zero, a cut next month would make the ECB the first major central bank to experiment with negative interest rates. Officials hope this move will raise inflation by weakening the euro and by making imports more expensive.

The euro area has been battling with persistently low inflation levels, raising the prospect of a Japanese-style era of deflation.

Low inflation
Inflation across the 18-country euro zone was 0.7 per cent in April, well below the ECB's mandate to keep inflation "close to and below" 2 per cent.

The German central bank has also said it may back purchases of private-sector assets. However, it has signalled its support for more unconventional moves depends on how forecasts for inflation for 2016 will change. While the June projections will almost certainly downgrade the outlook for inflation in 2014, economists are split on forecasts for 2016.

Mr Praet played down prospects of a quantitative easing programme, as has been initiated by the US Federal Reserve. – Additional reporting: Copyright The Financial Times Ltd 2014