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Low ECB rates set to last for rest of decade

The ECB surprised markets last week with its decision to ease monetary policy again.

Rates were last cut in June and there were strong hints at that time that it would not be lowered any further.

However, the weakness of the economy over the summer spurred it to take a further cut of 10 basis points to its key interest rates.

The refinancing rate was reduced to 0.05%, with the discount rate moving further into negative territory, after being cut to -0.2%.

The ECB also announced that it is to start purchasing non-financial private sector assets from next month, consisting of asset-backed securities and bonds. This is, in effect, a limited form of quantitative easing.

Meanwhile, the targeted longer-term, refinancing operations, which will provide cheap funding for banks, commence later this month. Taken together, all these measures represent a further significant loosening of ECB monetary policy.

It is hoped that the measures will enhance the provision of credit, counteract the marked fall in inflation and help fuel a recovery

Recent trends in the economy are a real cause for concern. The HICP inflation rate fell further to 0.3% last month. Meanwhile, the recovery in economic activity remains anaemic. GDP grew by a meagre 0.2% in the opening quarter of 2014. Growth then stalled completely in quarter two.

Indicators for July and August show the economy continuing to lose momentum.

The key eurozone composite PMI averaged 53.0 in July/August, marginally below the 53.4 average for quarter two. Meantime, the EC economic sentiment index averaged 101.4 in the past two months, a slowdown from the second quarter average of 102.2.

The weakness of inflation and activity indicators in recent months is reflected in the latest set of ECB staff macro-economic projections, published last week. These contained downward revisions to the HICP and GDP forecasts for 2014.

The ECB sees inflation averaging only 0.6% this year and remaining well below its 2% target rate in the next two years, at 1.1% in 2015 and 1.4% in 2016. The economy is set to grow by just 0.9% in 2014, with GDP growth forecast to pick up to 1.6% and 1.9% in 2015 and 2016.

The ECB retains an easing bias, reflected in the fact that it still views the risks to the economic outlook to be on the downside.

ECB president Draghi indicated that the Governing Council is unanimous in its commitment to use additional unconventional measures, such as a broad-based quantitative easing programme, should it become necessary to further address risks of too prolonged a period of low inflation.

Notably, last week’s easing decisions did not get unanimous support on the ECB Council. This suggests that it might be difficult to get approval from the council for a full-blown quantitative easing programme that involved the purchase of government debt.

What is clear, though, is that interest rates in the eurozone are likely to stay at virtually zero for a prolonged period. Looking at futures contracts, the market is not discounting any rate increase until late 2017 and rates are not seen rising to 1% until 2020.

As a result, the euro is losing ground, falling to $1.30 against the dollar and 80p versus sterling. This downward pressure on the euro is likely to continue if rates start rising elsewhere next year.

The low interest rate outlook is also having a profound effect on bond markets.

Ten-year German government bond yields have fallen below 1%. Irish 10-year bond yields are down to 1.7% and seem likely to fall further. The markets certainly believe that low ECB rates will last for the rest of the decade.

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