NICOSIA (Reuters) – Cyprus’s central bank cut interest rates by a quarter percentage point on Friday in an unexpected move that dealers saw as a possible testing of the waters on gradual convergence with eurozone rates. The cut took the key lending rate in the new European Union member to 5.25 percent and the deposit rate to 3.25 percent, narrowing the gap with the eurozone which Cyprus wants to join in 2007. «We noted lower inflationary pressures and an improvement in the fiscal situation,» Central Bank Governor Christodoulos Christodoulou told reporters. Dealers had not expected a rate change at Friday’s meeting of the bank’s Monetary Policy Committee. The market generally believed Cyprus would not tamper with rates in the run-up to joining the ERM-2 mechanism, the anteroom to euro adoption, one bank dealer told Reuters. Cyprus is expected to join ERM-2, a currency stabilization system, in the first quarter of 2005. But rates needed to move at some stage toward levels in the the eurozone rate, where the key rate is now 2 percent. The island, which has battled to bring a bulging fiscal deficit under control for the past two years, joined the European Union in 2004. Admission to ERM-2 and adoption of the euro had to be put on the backburner since the EU dictates a budget deficit of below 3.0 percent of gross domestic product. In Cyprus’s case the deficit reached 4.8 percent of GDP in 2004. A dealer at one commercial bank said the rate reduction caught the market completely by surprise. «In two or three months, the government is applying for ERM. We thought the central bank wanted to keep rates up to maintain the current level of the Cyprus pound against the euro,» said the dealer, who requested anonymity. «But it may be testing the waters, to see how the market will react.» Cyprus had not changed rates for 10 months. It jacked them up by a full percentage point last year to buffer the pound from a capital flight on the eve of Cypriot accession to the EU. At present, one pound equals 1.7086 euros. It fluctuates within an unofficial trading band of 15 percent but is routinely kept within 2.25 percent, in line with ERM rules.