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European Central Bank cuts interest rates to new record low

Investors were taken by surprise today after the ECB cut interest rates to a record low. Photo: Reuters

The European Central Bank has taken investors by surprise today by cutting interest rates in the eurozone from 0.5% to 0.25%. It's a record low - good news for borrowers but rather more worrying in what it says about the state of the eurozone.

The main trigger is the fact that inflation on the continent dropped suddenly to 0.7% - far below the ECB's target of "close to but below 2%."

There has been talk this week of the eurozone even slipping into deflation, reflecting a lack of demand in the economy. Deflation is the curse that helped condemn Japan to a 'lost decade,' something European authorities are desperate to avoid - and a threat Mr Draghi has just said he doesn't expect.

Furthermore the euro has been strengthening against other currencies, hampering exports. A cut in the interest rates paid on euros has immediately weakened demand for the currency and, seconds after the announcement, the euro weakened from buying US$1.35 to US$1.33 (a seven week low) which will help exporters.

Shares in the eurozone have leapt in response: the Cac40 index in Paris jumped over one percent in seconds.

This shows a number of things: first it confirms that the ECB does act when it sees fit - it's not all mouth.

Secondly it shows that the central bankers are concerned about the state of the economy in the eurozone: this matters to us as the UK is so dependent on selling what our companies do or make to the rest of Europe - and recent improvements there have helped our economy.

But how much difference will it make?

It could help the banks from peripheral countries, the weaker ones which are relying on financing from the ECB - which is now cheaper. But the transmission of ECB rates to the weaker countries' economies has long been broken - once banks lend on, in countries like Greece, Spain or Portugal, the rates are much higher.

In other words, real borrowers in these countries are paying more.

It won't make difference to banks in healthier parts of the eurozone either. Also a fall of only a quarter of a percentage point from already low rates is negligible, the impact is more the effect of surprise - and today's move has indeed taken may people aback.