The European Central Bank set a new precedent for unconventional post-crisis monetary policy Thursday, cutting one of its main interest rates below zero in an attempt to reverse falling euro zone inflation and stagnant growth.
Investors and analysts had been expecting the move. The bank's president, Italian economist Mario Draghi, had been hinting for months that the bank would take action to boost inflation, including suggesting in April the possibility of quantitative easing, along the lines of the program that the Federal Reserve has undertaken in the U.S. Like the Fed, the ECB has promised to keep interest rates low for a long time.
The ECB announced a package of measures in Frankfurt Thursday morning, including a decrease in all three of its policy interest rates. It cut its main policy rate to 0.15, and the interest rate on its deposit facility, paid on excess bank liquidity deposited overnight, from zero to -0.10 percent.
It is the first time that a major central bank has lowered rates below zero, although Denmark's central bank introduced negative rates in mid-2012 (like the United Kingdom, Denmark does not use the euro). Negative interest rates effectively charge banks to leave deposits at the central bank and are intended to spur them to loan out the funds instead.
A policy of negative rates would have been almost unthinkable prior to the financial crisis, and it remains logistically difficult.
In normal times, central banks conduct monetary policy by raising rates to tighten monetary conditions or lowering rates to ease them. In recent years, however, many central banks in developed countries have lowered rates all the way to zero or near zero without ushering in strong economic growth.
In response, many of them, including the Bank of England and the Bank of Japan in addition to the Fed, have used unconventional measures such as quantitative easing -- large-scale bond purchases -- to supplement low rate regimes.
The ECB turned to negative interest rates because euro zone growth has been stagnant and inflation has fallen below its 2 percent target with no sign of stopping. With 12-month inflation falling to a four-year low of 0.5 percent in May, the threat of outright deflation loomed:
Economic growth for the 18 countries of the euro area has been sluggish in recent months, following a double-dip recession of a drop in gross domestic product over much of 2012 and 2013. At nearly 12 percent in April, Unemployment remains disastrously high, although it has been falling in recent months. Unemployment in some struggling countries, such as Greece and Spain, remains above 25 percent.
The impact of the negative interest rate policy itself is likely to be limited. The Peterson Institute for International Economics' Jacob Funk Kirkegaard noted before Thursday's announcement that banks only deposited only an average of 28 billion euros in the deposit facility in May. While the practical significance of the negative interest rate move may be limited, it's likely that Draghi intended it as a signal that the bank is committed to easing monetary conditions and lifting inflation.
"While banks will likely be indifferent to this step, Frankfurt can hope that the public will be impressed by negative rates and keep inflation expectations steady," Kirkegaard wrote.
Furthermore, in a press conference following the decision, Draghi announced that further easing was possible and that the ECB's Governing Council "is unanimous in its commitment to using also unconventional instruments within its mandate should it become necessary to further address risks of too prolonged a period of low inflation."
That includes quantitative easing: Draghi announced that the ECB was engaged in "preparatory work" to buy private bonds if necessary.
He also announced further measures to ease credit among troubled banks, including $400 billion in financing for euro area banks to extend loans to businesses.
Together, Thursday's announcements amounted to a promise to ease money and credit. Initially, they had the intended effect: The euro fell against the dollar, and European stocks rose on the news.
Whether the move is credible in the eyes of investors and successful in lifting euro area inflation and growth, however, remains to be seen, as Allianz economist Mohamed El-Erian noted on Twitter:
Historic @ecb (2 of 2):Its an ambitious and impressive move. Question remains if monetary policy alone can achieve European economic liftoff— Mohamed A. El-Erian (@elerianm) June 5, 2014
Federal Reserve Chairwoman Janet Yellen and other Fed officials will be watching the European experiment closely. It will provide a case study of the effects of unconventional policies and a point of comparison for the Fed's own efforts. Furthermore, the Fed identified Europe's struggles as a strain on the U.S. financial system and a headwind for the economy throughout the region's double-dip recession. If the ECB is successful in staving off deflation and recession, conversely, Europe could help promote growth in the U.S.