Central banks and governments around the world will be keenly watching the outcomes of a radical plan of action unveiled by the European Central Bank on June 5 in Frankfurt. The objective is to spur growth and avert the threat of deflation in the sluggish Eurozone economy. In the most noteworthy part of the announcement, the ECB cut its benchmark interest rate to a record low and took the unprecedented step of lowering the bank deposit rate to below zero. Essentially that means the ECB will be charging lenders to park their funds with the central bank. The hope is that banks will lend to credit-starved businesses, especially small ones and those in the periphery of the Eurozone. A large liquidity enhancing package has also been announced. The moves are also expected to weaken the euro, thereby making exports from the zone competitive, and push up an inflation rate that had dropped to a four-year low of 0.5 per cent in May. It is for the first time that a major central bank has taken as drastic an action as to push key interest rates into negative territory. Neither the Bank of Japan in its two-decade battle with deflation, nor the U.S. Federal Reserve in the wake of the recession, has gone so far. Observers attribute the radical steps to the president of the ECB, Mario Draghi, who two years ago brought stability to the Eurozone by acting forcefully to preserve the euro.
Given the serious threat of deflation accompanied by a high rate of unemployment, particularly in countries on the outskirts of the Eurozone, the ECB’s action has won more supporters than critics. As was amply demonstrated in Japan, deflation has several deleterious consequences. It cuts into business profits, raises real debt, and discourages household consumption and investment. The central bank’s gamble might pay off if businesses and consumers start believing that prices will not fall further. It is therefore a question of managing expectations, a topic that has been engaging central banks around the world. For India and other developing countries which face rising prices, the threat of deflation is extremely remote. The ECB’s package is nevertheless important because if it succeeds in reviving the Eurozone economy, India’s trade and other economic relations with an important grouping will benefit. The ECB has also promised to supplement its interest rate action with a massive bond purchase programme, akin to the U.S. Federal Reserve’s quantitative easing. If the plan of an ultra-soft monetary policy in Europe materialises, it will help India and other developed countries face with greater equanimity the consequences of the Fed’s ongoing programme of withdrawal of its quantitative easing.
