ECB cuts rates to new low after inflation tumble

The European Central Bank cut interest rates to a new record low on Thursday, responding to a slump in inflation way below its target that has sparked fears the euro zone’s economic recovery could stall.

The 23-man Governing Council had faced intense market scrutiny in the run-up to Thursday’s decision after a shock slump in euro zone inflation to 0.7 percent in October – far below the ECB target of just under 2 percent.

Calls from government ministers and industry – the loudest from Italy – for the ECB to loosen policy to help bring down the euro’s exchange rate had also heaped pressure on the Council, though few analysts expected a move this month.

The ECB cut its main refinancing rate to 0.25 percent. It held the deposit rate it pays on bank deposits at 0.0 percent and cut its marginal lending facility – or emergency borrowing rate – to 0.75 percent from 1.00 percent.

“Wow! This confirms how the ECB under Draghi has changed. They’ve become pretty pro-active,” said ING economist Carsten Brzeski.

“The ECB knows that a rate cut at the current juncture will do only very little to kick start the economy or to fight deflation,” he said. “In my view, it’s aimed at further weakening of the euro exchange rate.”

The euro fell to a 7-week low against the dollar after the decision.

All but one of the 23 money market traders polled by Reuters this week expected the ECB to remain on hold at Thursday’s meeting, pending a clearer view about where euro zone inflation is heading.

Attention now shifts to ECB President Mario Draghi’s 1330 GMT news conference.

Markets will be listening for any indication of whether the cut marks the end of the ECB’s policy easing cycle and what it means for the ECB’s forward guidance on interest rates.

Since July, the ECB has said it expects to keep its key rates “at present or lower levels” for an extended period.

Markets will also be alert to any signals that the ECB could offer banks another injection of liquidity with long-term loans, known as LTROs.

Prior to Thursday’s meeting, three strains of thinking appeared to be running through the Council, people familiar with the internal debate said.

One group was content to keep open the option of another round of long-term loans to banks, another favored an interest rate cut, while a third was prepared to sit this one out.

Adding to the ECB’s dilemma over how to support a fragile recovery is a fall in excess liquidity – cash beyond what lenders need to cover day-to-day operations – as banks repay 3-year ECB loans early before a health check next year.

These early repayments are expected to push interbank lending rates higher over time and the ECB has been considering pumping more liquidity into the system to offset this development.

In a Reuters poll last week, 44 out 59 analysts surveyed said the ECB would inject more liquidity, probably early next year. It could do so, for example, by launching another long-term refinancing operation (LTRO).

The cut in the main refinancing rate to 0.25 percent could potentially also slow the pace of LTRO repayments, as lower interest costs make it more attractive for banks to hold on to the loans for longer and invest them in higher-yielding assets.

Draghi will use his news conference to try to dispel concerns that October’s inflation drop raises the specter of deflation in the euro zone.

The head of Italy’s business lobby Confindustria said on Wednesday the country was in a worrying “situation of deflation.”

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