The ECB`s QE and negative interest rates: how they work

The European Central Bank on Thursday fired off a new volley of monetary policy shots aimed at pushing up chronically low inflation in the euro area. 

Here are the different measures and how they work. The ECB is extending its programme of so-called quantitative easing or QE from the initial deadline of September 2016 until March 2017 and possibly beyond. And it is also widening it to include additional categories of eligible bonds. 

Like the US Federal Reserve and the Bank of Japan before it, the ECB in March embarked on a programme to buy up public sector bonds. 

The aim is simple: by buying the bonds en masse, their price goes up and their yields come down, encouraging banks to place their money elsewhere, such as loans to businesses and households.

Low interest rates mean businesses and households are less inclined to leave their money in the bank, while at the same time more likely to borrow money to spend and invest. This boosts economic activity and eventually pushes up prices. 

QE also weighs on the value of the euro, because with low interest rates, investment in eurozone assets become less interesting for investors from other regions, which leads to an outflow of cash from the single currency area and pulls down the euro against other currencies. That is advantageous for exporters because it makes eurozone exports cheaper in, say, dollar and yen terms. At the same time, the cost of imports rises, pushing up headline inflation. 

For the central bank, one of the aims of QE is to persuade economic players that prices will eventually rise, warding off fears of deflation, a dangerous downward spiral of falling prices.

While falling prices might appear to be good for consumers, if they become entrenched, consumers could delay purchases in the hope of even lower prices later, which in turn prompts companies to hold off investment. 

Deflation is a trap that is very difficult to get out of, as demonstrated by the case of the Japanese economy.

Under the first round of QE, the ECB plans to buy 1.14 trillion euros of assets at a rate of 60 billion euros per month until September 2016. So far, the ECB has purchased 540 billion euros worth of bonds. By extending it at least until March 2017, the overall volume will amount to 1.5 trillion euros. 

While the programme initially appeared to work, the falling oil price and economic slowdown in China has pulled down inflation again. Area-wide inflation stood at just 0.1 percent in November. 

Credit activity is however, slowing picking up. 

ECB chief Mario Draghi said the bank was ready to "recalibrate" the programme again should circumstances require.In 2014, the ECB became the first major central bank in the world to use negative interest rates. That means that banks parking their money with the central bank are actually charged for doing so. By penalising the banks for hoarding their cash, the ECB is giving them the incentive to loan the money out, thereby pumping more cash into the economy. 

The ECB lowered its so-called deposit rate to minus 0.2 percent in September 2014 and has now cut it further to minus 0.3 percent. 

The perceived risks of negative interest rates -- for example that savers would rather store their cash under their mattresses than take it to the bank -- has not materialised, not least because banks have not passed on the costs to their customers. 

At the same time, negative interest rates erode the profits of banks, raising doubts about their stability. 

The ECB`s two other key lending rates -- the refinancing or refi rate and the marginal lending rate -- are still positive and were left unchanged at 0.05 percent and 0.3 percent respectively.