The European Central Bank on Thursday cut interest rates and took a raft of unconventional steps to prevent the 18-country eurozone from sliding into a bout of deflation that could kill off a muted economic recovery.

The ECB's steps aimed to raise inflation and push more credit into an economy where lending is weak. The steps include cheap, long term loans to banks, tied to the understanding banks would loan the money to businesses, boosting growth.

The ECB also took the unorthodox and untested step of imposing a negative interest rate on money banks deposit with it, an attempt to push them to lend that money, not hoard it.

"Uncharted waters"

The move puts the ECB into "uncharted waters", according to Andrew Labelle, economist at TD Bank.

"There are few instances of central banks using negative rates and certainly it has never been done by so prominent a central bank," Labelle wrote in a note to investors. 

'There are few instances of central banks using negative rates and certainly it has never been done by so prominent a central bank'- TD Bank economist Andrew Labelle

"Time will tell whether cutting the deposit rate will encourage banks to increase lending, will lead to capital outflows, or whether banks will treat this as a cost of operating and simply pass it on to consumers and businesses."

The ECB took the conventional step of cutting its main interest rate, the refinancing rate, from a record low of 0.25 per cent to 0.15 per cent. It went well beyond that, however, reducing the rate it pays on money deposited by banks from zero to minus 0.1 per cent.The actions contributed to a rally in European stock markets and a further fall in the value of the euro.

ECB takes drastic action

ECB President Mario Draghi also told a press conference that on top of those rate cuts, the ECB would take a number of drastic steps:

  • Offer long-term loans to banks at cheap rates until 2018. The targeted loans would be charged a fixed rate, meaning that the rate could not rise, even if the ECB raises its benchmark. That gives banks confidence they have cheap funding out through 2018. The loans would be capped at 7 per cent of a bank's lending to companies.
  • Start doing "preparatory work" on a program to buy batches of loans to small businesses in the form of bonds, a step to funnel more credit to companies through financial markets.
  • Stop collecting weekly deposits aimed at offsetting the monetary effects of earlier bond purchases. That would leave an additional 175 billion euros in the financial system that banks could in theory use to lend to each other or to companies.

In reference to the moves, Draghi said "together, the measures will contribute to a return of inflation rates to levels closer to two per cent.

"Inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, two per cent," he said.

Draghi also did not close the door to a still more drastic step, large-scale purchases of bonds to inject newly created money into the economy. Many economists say that would be the most effective step the bank could take in boosting inflation.

'In pursuing our price stability mandate, today we decided on a combination of measures to provide additional monetary policy accommodation and to support lending to the real economy'- ECB President Mario Draghi

The U.S. Federal Reserve, Bank of Japan and Bank of England have all made such purchases. But the ECB has held off due to the legal and practice complexities of such purchases in a currency union with 18 different members.

Draghi said ECB policymakers were in agreement about pursuing unconventional measures to boost inflation if it stays too low. That's important because it shows that Germany's Bundesbank is on board with the new package of measures.

"In pursuing our price stability mandate, today we decided on a combination of measures to provide additional monetary policy accommodation and to support lending to the real economy," he said.

Inflation at 0.5 per cent

At last count measure, inflation was 0.5 per cent, far below the ECB target of 2 per cent. Draghi said inflation this year would be 0.7 per cent, down from the previous forecast of 1 per cent. However, he said inflation in 2015 would rise to 1.1 per cent and 1.4 per cent in 2016.

Weak inflation has raised fears the eurozone may slide into outright deflation, a sustained drop in prices that can choke off growth as consumers and companies delay spending in hopes of bargains. The eurozone economy grew only 0.2 per cent in the first quarter, and unemployment remains high at 11.7 per cent.

The new approach caused big movements in the markets. Stocks rose, with Germany's DAX index trading above 10,000 for the first time. The euro fell to $1.3555 from about $1.3600. Looser monetary policy tends to weaken a currency.

"I think it's safe to say the markets fully approved of the measures announced by Draghi," said Craig Erlam, market analyst at Alpari.

"Moreover, I don't think the sell-off is over yet," he added, saying the euro is likely to touch $1.34 over the next week.

with files from CBC News