2013-60 Monetary policy in action

Somewhat unexpectedly, the European Central Bank lowered the short-term interest rate it controls to the lowest level ever (0.25%).

• Why was it unexpected? Of the 23 analysts polled before the decision, 22 thought there will be no change.
• What was the reason for the cut? The apparent reason is that inflation in the Euro - area is very low, at 0.7%. The ECB target for inflation is just below 2%.

As we discussed some time ago, a low rate of inflation, if it falls further, may become deflation. And everyone is afraid of deflation.
Note that, unlike the proposals we discussed in posting 2013-55 and 2013-57, the ECB is not at all aiming for a high rate of inflation. Rather, it wants to bring inflation closer to the target.

• Are there other reasons for the cut? perhaps. The Euro-area economy is weak (except for Germany and a few other countries) and the Euro has appreciated, making life difficult for exporters. Since, as we discussed in chapter 4, a lower interest rate leads to depreciation of the currency, making exports cheaper and imports more expensive.
• Another reason may be that the European economy is weak. Lower short-term interest rate, if it results in lower long-term interest rates, will provide stimulus to the economy. We will discuss the link between short-term and long-term interest rates today.

Indeed, markets think there will be an  improvement in the economy and they are up.