ECB FOCUS-ECB shy of zero rates, but may get there by stealth

FRANKFURT Jan 22 (Reuters) - The European Central Bank may be pursuing a zero interest rate policy by stealth, even though policymakers say they have no plans to follow other central banks in slashing benchmark rates down to the bone.

ECB President Jean-Claude Trichet has said there are no plans to cut benchmark rates to zero, telling Japanese television after last week's 50 basis point cut: "If you ask me the question 'if you go to zero', I would say no." (For story, double-click on [ID:nT285020]) But some say the ECB may be pursuing a de facto zero interest rate policy, or ZIRP, as it allows the cost of funds by some measures to drop well below its benchmark 2 percent rate.

Short-term money market and inflation-adjusted interest rates are already very low, meaning the economy ought to get a shot in the arm while the ECB keeps some firepower back for further cuts to official rates -- allowing the central bank to have its cake and eat it too.

Economists say the low cost of funds bolsters the odds that the ECB will cut its policy rate no lower than 1 percent this year, the level most analysts polled by Reuters expect to see by September. [ECILT/EU]

A policy rate of 1 percent would take the interest rate the ECB pays on overnight deposits -- which has taken on a more prominent role as the de facto floor for very short-term lending in the last few months -- down to zero.

"If they aim to stop at 1 percent there would be still a bit of margin for conventional monetary policy in case things turn even worse than they expect," said Rainer Guntermann at Dresdner Kleinwort.

"This would imply that the ECB's deposit rate would drop to zero and if the ECB continues to flood markets with unlimited liquidity, then you would expect overnight rates like EONIA moving very close to zero -- maybe it's part of the strategy."

Until last October, the ECB aimed to keep overnight lending rates close to its policy rate. But then it extended its horizon and started lending banks unlimited funds for up to six months at its policy rate, pushing overnight lending rates below this level. The ECB has said the provision of unlimited liquidity will continue as long as needed and at least until March 31.

"SECRET ZIRP STRATEGY"

Average overnight rates, or EONIA, fixed at 1.498 percent on Wednesday, mid-way between the ECB's 2 percent policy rate and the 1 percent overnight deposit rate. EONIA=

Morgan Stanley economist Elga Bartsch said EONIA could fall as far as zero if the ECB cut its policy rate to 1 percent, which she dubbed a "secret ZIRP strategy".

"That's a side effect of quantitative easing, if you provide extra liquidity to the market the (overnight) rate can fall below your policy rate," she said.

Bartsch noted that real rates, or official rates adjusted for inflation, are already close to zero using the ECB's goal of inflation of below but close to 2 percent as a yardstick.

But economists differ on how to calculate real rates, with some saying that inflation expectations INFLATION01 or the current inflation rate are a fairer measure of the real cost of money.

Using December's inflation rate of 1.6 percent, the real interest rate would be 0.4 percent. RBS economist Jacques Cailloux said the real rate could act as a brake in future.

"The ECB has a genuine issue with bringing rates to extremely low levels," he said.

"While Trichet refused to provide a specific level of where that floor might be, we would think that the Council might be unwilling to bring real rates to below 0 percent. This would imply that 1.5 percent nominal rates would constitute a very difficult level to breach (assuming no deflation risks)."

TRAP TRIP

In explaining the ECB's strategy at last week's news conference, Trichet threw economists a curve ball by saying the ECB wanted to avoid a liquidity trap, where a combination of deflation, zero interest rates and ample liquidity mean monetary policy fails to have any impact on the economy.

The conventional wisdom -- also cited in ECB research papers -- holds that the best way to avoid a liquidity trap is to cut rates quickly to very low levels.

But economists said later comments from Trichet and other policymakers made it clear that very low rates were the very trap the ECB wanted to avoid.

"The Governing Council has taken the opposite view, that we have to be wary about cutting rates too far because it could become trapped," said Barclays Capital economist Julian Callow.

Some say the ECB is rash to dismiss cutting rates as low as they can go, given the dire economic outlook.

Other central banks have not been shy: the U.S. Federal Reserve has a target rate of 0-0.25 percent, the Bank of Japan is at just 0.1 percent and the Swiss National Bank is at 0.5 percent as the global economy heads into one of its toughest years ever. ECONCBIR

The ECB has acknowledged that staff forecasts for the eurozone economy to contract by up to 1 percent this year will probably be too optimistic, and the European Commission predicts a shrinkage of 1.9 percent.

"If the economy is slowing down rapidly, it makes sense for a central bank to cut rates aggressively," said Stefan Gerlach, professor at Frankfurt University's Institute for Monetary and Financial Stability.

"It's hard to see that if economic conditions warrant it, why any central bank would not want to cut rates to zero."

* USEFUL LINKS *

For ECB working papers on zero interest rates:

here

here

For liquidity trap factbox, double-click on [ID:nLG196759]

For a blog, see: here