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Focus on deposit rate as ECB ponders cuts

FRANKFURT (MarketWatch) -- The European Central Bank is widely expected to drop its key lending rate to a record low on Thursday, but economists remain unclear what policy makers will do with the bank's deposit rate as it enters uncharted territory.

Surveys show economists are overwhelmingly looking for the ECB to cut its refi rate by 0.25 percentage point to 0.75%, taking it below the 1% level for the first time in the central bank's history.

It would also mark the third rate cut delivered on Mario Draghi's watch since he took over as president of the central bank last November.

"In the wake of last week's EU summit, which offered no relief to the problems immediately confronting the euro-land banking system or the economy, we think the ECB has little choice but to ease monetary conditions," said Carl B. Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y., in a note to clients.

The ECB will announce its rate decision at 1:45 p.m. Frankfurt time, or 7:45 a.m. U.S. Eastern. Draghi's monthly news conference will begin at 8:30 a.m. U.S. Eastern.

Cutting the refi rate, however, will force the ECB Governing Council to decide what it wants to do with the "corridor" between the key lending rate and its deposit rate. The deposit rate is what commercial banks receive when they stow money overnight at the ECB.

The deposit rate stands at 0.25%, leaving a 75-basis-point corridor between it and the refi rate. A basis point is 1/100th percentage point.

`Dysfunctional' money markets

Changes will have implications for money markets and interbank lending, which Draghi described as "dysfunctional" as recently as last month.

"We expect the deposit rate to be cut by 10 basis points to 0.15% but there is a broad range of possible outcomes, which could leave the deposit rate anywhere between unchanged and a 25-basis-point cut," wrote economists at Danske Bank in Copenhagen. "We are in uncharted territory."

Proponents of a cut in the deposit rate contend it may encourage banks that have been parking extra cash at the ECB to lend it to other banks in the euro zone.

Victoria Clarke, economist at Investec in London, argued that a change in the deposit rate would be a mistake. Sending the deposit rate to zero would likely increase "pass-the-parcel-type" short-term interbank lending while doing little to boost lending to the private sector, she argued.

Leaving the deposit rate at 0.25% and narrowing the corridor with the refi rate to 50 basis points would provide a financial boost for banks, leaving them better positioned to support private-sector credit flows, she said.

On the other hand, Elwin de Groot, economist at Rabobank International in Utrecht, Netherlands, said a quarter-point cut in the deposit rate would, in principle, be more effective than a similar cut in the refi rate.

A deposit-rate cut would be more likely to translate into a bigger decline in interbank lending rates, he said, in a note.

De Groot, however, questioned whether such a move would inspire banks in the euro zone's core to resume lending to banks in the periphery. Also, it's not clear why banks would start lending to the private sector when loan demand remains subdued, he said.

Summit decisions

The European Union summit last week cheered markets after leaders agreed to allow the region's permanent rescue fund to eventually directly recapitalize Spain's ailing bank sector, ensured that loans from the fund won't be senior to other bondholders, and took steps to ease rules regarding the ability of the euro-zone's rescue funds to buy up distressed government debt.

The euro bounced higher in the wake of the summit meeting and has held its own in recent sessions. The euro (EURUSD) changed hands at $1.2559 in recent action versus the dollar, little changed from its level in North American trade late Tuesday.

Economists are also divided on whether the ECB will move to boost overall liquidity by offering another three-year long-term refinancing operation, or LTRO.

A pair of such operations in December and February were credited with lowering fears of any near-term, funding-related banking failures while also providing banks with ammo to resume purchases of government bonds.

Marie Diron, senior economic adviser to the Ernst & Young Euro-zone Forecast, contends the ECB could cut its refi rate by a half point but doubts the central bank is ready to provide another round of long-term loans amid a lack of evidence of regionwide lack of liquidity.

Weinberg contends, however, that the ECB is likely to open the long-term liquidity taps after moving last month to ease rules governing the collateral banks can post to secure loans from the central bank.

"It is more comfortable to lend out cash when you have it on hand for more than a week," he said.

Before the ECB acts, the Bank of England will announce the outcome of its policy meeting at 7 a.m. U.S. Eastern.

Economists widely expect the bank to boost the size of its quantitative-easing program by another 50 billion pounds ($78.3 billion), bringing it to £375 billion. Read Market Extra and ECB, BOE rate expectations.

Of course, any sort of rate cut isn't a foregone conclusion.