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On Thursday 2nd May 2013 the ECB cut its base rate interest rate to 0.5%, down 25 basis points from 0.75% (source: yahoo!).
Why was the base rate lowered?
Inflation in the Eurozone currently sits at 1.2%, this is lower then the target rate of 2% (source: reuters). The base rate filters through the economy to affect the inflation rate, this is demonstrated by the transmission mechanism in figure 1:
From my own experience on the matter I will not explain the whole of the transmission mechanism, as it relies on various factors and can easily turn this blog into an extended essay. However the basic assumption, which has been proved in theory (source: MPC), is that a decrease in the official rate will increase inflation. Therefore helping the ECB hit its target of 2%.
Unemployment is another factor as to why the interest rates have been cut. Unemployment in the eurozone at the moment is disastrous, and the ECB is hoping to use a lower official rate to help. The official rate helps by filtering through the economy (figure1) and in stage 2 increasing Aggregate Demand (AD, total demand for goods and services). This helps to decrease unemployment, as an increase in AD will increase firm profitability (as they are selling more products) and as a result will help increase employment as firms seek to meet the new, higher, demand.
Theoretical results from a cut in the base rate
Share Prices rise, Ioannidis and Kontikonidas (paper) proved that the base rate is linked to the discount rate of shares. When the base rate lowers, so does the discount rate, and as a result the present value of the future income flows from the firm increase – pushing up the share prices. If you are unsure what I am referring to, use this calculator and play around with the interest rate value, if you decrease it you will see the present value increase (keep the time period and future value the same).
Inflation rise and Unemployment fall, as discussed earlier.
Expectations, markets have so far reacted to the news of a cut with general positivity, with Asian markets rising as a result (source). This is because investors react to future prospects that might occur as a result of the rise in interest rates, and one of these future prospects is that AD will indeed rise and that unemployment will fall – putting a more positive outlook on the eurozone economy.
Borrowing rates will decrease, retail bank rates are also directly affected by the official bank rate. By decreasing the bank rate, the cost of borrowing for euromembers will decrease, and also the interest payments for saving will also decrease. This should push up borrowing, and reduce saving, helping increase the Aggregate demand in the economy and improving the economic prospects.
Alot of these results rely on various other factors, for example share prices in the eurozone did not rise as much as expected due investor caution over the US non-farm payroll statistics being released. Furthermore it is important to note that the Monetary Policy Committee (Bank of England) believe that interest rate cuts take up to one year or more to have their full effect, therefore short term changes in the stock market and investor sentiment is not a great indicator of the cut’s effects.
However the general theoretical assumption is that a decrease in the official bank rate will push up inflation and increase aggregate demand. This should help improve economic conditions in the eurozone over the next year.
Something to think about… Lloyd Blankfein, Goldman Sachs CEO, recently had a high-profile press conference where he expressed his concern for deflation (low/negative inflation) (source – Bloomberg). The ECB then cut interest rates on the back of inflation being too low. For those who are intrigued by the theory that Goldman Sachs rule the world, this might provide fuel for further conspiracies.