By: Dr. Mike Campbell
The European Central Bank (ECB) has held interest rates unchanged at 1%. The rate has remained unchanged for 19 consecutive months now. The idea is that the provision of “cheap” money will stimulate economic recovery and create new jobs, so the rate is unlikely to rise until inflationary pressure becomes significant or the ECB judges that the recovery is sufficiently robust to allow borrowing costs to rise to more traditional values.
The ECB rate is less than the official Eurozone inflation level and consequently it is a stimulus measure rather than a commercially set rate at which ECB lends money to financial institutions. Commercial banks, of course, loan money to businesses and individuals at higher rates.
The ECB has also made it clear that it will continue to purchase government bonds from within the Eurozone. Purchasing bonds essentially creates demand for them and, as a consequence, the yields that they must offer to attract investors fall.
This means that it is cheaper for the issuing nation to fund its debt. The Federal Reserve is using the same mechanism to pump liquidity into the US markets and drive down borrowing costs in its second round of quantitative easing. Fears over a default on Irish bonds had the opposite effect and pushed up the yield that had to be offered to attract investors. This led to the latest episode of the European sovereign debt crisis and ultimately required that the EU and IMF provided funding to Ireland at a guaranteed interest rate.
Initially, the Euro fell on the news of the bond purchase plans as analysts had expected an immediate purchase, but as the news was digested, the value of the Euro appreciated against other major currencies.