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After sitting on the sidelines for the past few months, central banks around the world decided that it was finally time to spring into action. This morning, the Bank of England, People's of China and the European Central Bank eased monetary policy, triggering widespread volatility in the foreign exchange market. The European Central Bank's decision to cut its refinancing rate to to a record low of 0.75% stripped the EUR/USD of all its EU Summit gains even though ECB President Draghi refused to comment on the possibility of LTRO3.

While the decision was largely anticipated, it was nonetheless significant enough to drive the EUR/USD sharply lower. In our ECB Preview, we wrote that a rate cut by the ECB could be a win-win for the EUR and this could still be true once the dust settles and investors realize that the ECB has finally stepped out of the shadows and taken steps to actively stimulate the eurozone economy. However this may take a few days and will only happen if equity traders respond positively to the global easing. Interestingly enough, Dow futures are trading lower this morning, which could be a result of Draghi's extreme pessimism.

The main motivation for the rate cut from the ECB was the downside risks to growth in the whole eurozone and the prospect of lower inflationary pressures. Although the EU Summit helped to stabilize the financial markets and made the market environment a little less tense according to Draghi, it did not remove the pressure that austerity has on growth. The central bank believes that Q2 data will show renewed weakness and the recovery from that will be gradual. Most importantly, inflation is projected to fall below the 2 percent target in 2013, which provides the ECB with the flexibility to cut interest rates without the risk of stoking significant inflationary pressures. Aside from the 25bp reduction in the refinancing rate, the ECB also voted unanimously to lower its marginal lending rate to 1.50% and its deposit rate to zero.

As for further easing, Draghi's refusal to pre-commit to future decisions means no decisions have been made about a third round of LTRO but based on his extreme pessimism and the price action in the EUR/USD, investors are assuming the ECB will ease again.

PBoC Action Says More About Chinese Economy than Economic Data

While the ECB rate announcement triggered the biggest reaction in the FX market this morning, the largest surprise was the announcement from the People's Bank of China, which lowered the reserve requirement ratio, cut the deposit rate by 25bp and the lending rate by 31bp. In light of the better-than-expected Chinese PMI numbers, no one anticipated a rate cut from the PBoC and the decision to ease only confirms our belief that China is cooking the books and doing much worse than the numbers suggest. The Bank of England also increased the size of the Quantitative Easing program by GBP50 billion to GBP375 billion. Monetary policy committee members felt that the economy was performing worse than it had anticipated and with inflation likely to edge lower and economic indicators pointing to even weaker growth in the near term, it felt the need to take steps to strengthen the economy immediately. It is clear that the prospect of lower inflationary pressure in Europe (which will most likely be caused by lower growth) was a big motivation for the decisions made by the BoE and ECB today.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: ECB Rate Cut Motivated By Growth And Inflation