ECB cuts rates in surprise to counter deflationary dangers

The European Central Bank cut its key interest rates in an unexpected move Thursday amid concerns that slowing inflation in the euro area could turn into a vicious circle of falling prices. The ECB took financial markets by surprise by cutting its central "refi" or refinancing rate by a quarter of a percentage point to a new record low of 0.25 percent. The move comes after new data showed eurozone inflation slowing to a four-year low of 0.7 percent last month, raising the spectre of deflation. The International Monetary Fund welcomed the rate cut, saying it was justified to shore up growth in the fragile eurozone. "The decision is fully warranted by the weak inflation dynamics and substantial slack in the economy," said IMF spokesman Gerry Rice. "We strongly welcome the decision by the ECB today which we believe can help support the nascent recovery in the euro area," Rice said. "The recovery is fragile and the outlook remains challenging" for the region, he said. Most ECB watchers had expected the bank to keep its gunpowder dry at its monthly policy meeting at least until next time, when it would have compiled new inflation and growth forecasts. But ECB chief Mario Draghi justified a move this month by saying that the 17 countries that share the euro "may experience a prolonged period of low inflation". Eurozone interest rates have never been so low, but the ECB still has further ammunition up its sleeve, Draghi said. "We have a whole range of instruments we can mobilise if necessary," Draghi told reporters. "In principle, we could even cut further." It could take its deposit rate -- currently at zero percent -- into negative territory for the first time. Or it could roll out more liquidity measures in the form of LTROs or long-term refinancing operations, the ECB chief suggested. Euro strength not a factor Draghi rejected suggestions that the euro's recent strength was a factor behind the rate cut. A strong euro weighs on eurozone exports, undercutting the region's still very fragile economic recovery. The euro's strength "played no role in today's decision. I don't think it was even mentioned," he said, though adding that the exchange was important for price stability. Economists admitted they were caught off-guard by the move, but suggested it was more symbolic and the economic impact would be limited. Marie Diron at EY Eurozone Forecast felt "this rate cut is good news for the eurozone." However, it "is not enough to remove the risk of deflation altogether" and further monetary policy action would be possible in the next few months, Diron suggested. Commerzbank chief economist Joerg Kraemer believed it was not actually the fear of deflation that had forced the ECB's hand, because the low rate of inflation could be attributed to increased price competitiveness in countries such as Ireland, Spain and Portugal. Kraemer suggested the ECB was trying to anchor investors' expectations for money market rates close to zero percent for a very long time. "This keeps the hunt for yield alive which creates demand for government bonds of peripheral countries and thus stabilises the currency union which lacks a broad-based reform breakthrough in the peripheral countries, especially in Italy," the expert argued. ECB under Draghi more pro-active Carsten Brzeski at ING DiBa felt that the ECB under Mario Draghi "has become much more pragmatic and pro-active than under any of Draghi's predecessors. "Contrary to past experiences, the ECB now seems to follow the motto of 'even if it does not help, it does not hurt either'." Nevertheless, Brzeski was sceptical that the ECB could actually do much more. "Even if Draghi reiterated that the zero (boundary) for interest rates had not been reached, we are doubtful that the ECB can still offer many of these big-bang days in the future," he said. Berenberg Bank economist Holger Schmieding was more enthusiastic. "Once again, the Draghi ECB has shown that it can act decisively," he said. "We do not expect the ECB rate cut to achieve a lot, rates were very low anyway. We do not expect the cut to do any damage either. But the very fact that Draghi today demonstrated again a capacity to act fast and energetically strengthens our core conviction for Europe," he said.   RBS economist Richard Barwell similarly believed the move "will force the market to revisit its assessment of the ECB reaction function." But Capital Economics economist Jonathan Loynes said "a small cut in interest rates is not going to transform the economy. "And while the ECB's arsenal is not yet completely spent, the central bank cannot address the fundamental problems of high debt, structural rigidities and a lack of competitiveness in the periphery which will continue to weigh on the currency union's economy," he warned.