Europe takes bold step on deflation

The European Central Bank, in a bid to boost the economy, cut interest rates to a new record low Thursday and started charging banks that use it to park cash.

Worried that very low inflation could snuff out Europe’s weak recovery and tip the economy into a downward spiral, the ECB cut its main interest rate to 0.15% from 0.25%.

It also took a step into the unknown by cutting its deposit rate from zero into negative territory.

That has the effect of charging banks for deposits they stash with the ECB, in theory providing an incentive to lend the money to firms and consumers instead.

It said further “monetary policy measures” would be announced after a news conference due to begin at 8.30 a.m. ET.

ECB President Mario Draghi and other officials have spent the past month talking up the likelihood of action, and both interest rate moves were widely expected.

The euro has fallen 2% against the dollar as a result, bringing some relief to European exporters and potentially easing the downward pressure on prices by making imports more expensive.

The euro fell slightly after Thursday’s announcement.

Why is the bond market freaking out?

The additional measures could include new cheap, long term loans to banks, possibly with the explicit aim of boosting lending to the thousands of small businesses that form the backbone of the European economy and lack access to other sources of finance.

But most economists expect the ECB to stop short of a full-blown Fed-style bond-buying program, although Draghi may well stress that this remains an option should conditions deteriorate still further.

Consumer prices rose by just 0.5% in the eurozone in May. The ECB targets inflation of just below 2% over the medium term, but its own forecasts show that level won’t be reached through 2016.

Very low inflation can be as damaging to an economy as excessive price increases.

If households and businesses expect inflation to stay depressed for a long period, they may postpone spending and investment, triggering a downward spiral and raising the risk of outright deflation.

It also makes it harder for countries to pay off debts, and forces weak European economies to make real cuts to wages to compete with countries like Germany.

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