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May 02, 2013, 05.31 PM IST | Source: Reuters

ECB cuts rates to support flagging euro zone economy

The European Central Bank cut interest rates for the first time in 10 months on Thursday, driven to act by an economy wallowing in recession and freed to do so by sharply falling inflation.

ECB cuts rates to support flagging euro zone economy

The European Central Bank cut interest rates for the first time in 10 months on Thursday, driven to act by an economy wallowing in recession and freed to do so by sharply falling inflation.

The ECB lowered its main interest rate by a quarter point to a new record low of 0.50 percent in response to a drop in inflation well below its target level, and rising unemployment.

The cut was widely expected, after ECB President Mario Draghi said last month the bank stood ready to act. He will hold a news conference at 1230 GMT to explain the decision.

Also Read: 25 bps ECB rate cut may not do much for mkt: Nick Parsons

Economic data over the last month have bolstered the case for action, with unemployment hitting a record high in April, when inflation saw its biggest monthly drop in over four years, to 1.2 percent.

"The ECB is playing it safe, even though they know the effect is likely to be limited," Nordea analyst Anders Svendsen said of the cut.

"The key for the market is the tone. If the ECB comes out with other measures as well to help SME (small- and mid-sized enterprise) lending that will be positive but if they say the cut was all they had, I think there will be disappointment."

The euro rose to USD 1.3191 and German 10-year government bond futures edged higher after the decision.

The sharp drop in inflation, from 1.7 percent in March, pressured the ECB to cut rates to honour its mandate to deliver price stability, which it defines as inflation close to but below 2 percent.

The sudden slump in price pressures has also raised the possibility of the ECB having to look at policy tools beyond interest rates to counter any further slide in inflation.

"Ultimately, we think the ECB will have to purchase private-sector assets in order to fix the transmission mechanism," said Andrew Bosomworth at PIMCO, the world's largest bond fund.

The ECB wants to improve the transmission of its monetary policy so its low rates reach all corners of the euro zone.

The bloc's south is not benefiting to the same extent as the north from the ultra-low rates. If they are lending at all, banks there are charging companies and households more for loans than their peers in the north because of higher funding costs and credit risks.

SMALL COMPANIES, BIG PROBLEM

The ECB has repeatedly voiced its concern about the impact this has on lending to small- and medium-sized enterprises (SMEs), which have little alternative to bank funding and are a key engine for growth in the currency bloc.

It has said it is studying options to address the problem, but little is expected to have been decided at Thursday's policy meeting. It is one of two that the ECB holds outside of Frankfurt each year.

"We suspect that the ECB will avoid making any formal statement on a potential SME programme ... as it continues to weigh the pros and cons of such measures," said Frederik Ducrozet, senior euro zone economist at Crédit Agricole CIB.

Some ECB policymakers are reluctant to try to fix too many of the euro zone's problems, eager to push onto governments the issue of dealing with SME lending. Draghi must balance this reluctance with the pressure for action.

In Germany, the ECB has even faced resistance to a rate cut.

German Chancellor Angela Merkel said last week the ECB would have to raise rates if it were looking at Germany alone.

German insurers and the county's dominant savings and cooperative banking sector have also joined up to speak out against looser ECB monetary policy, saying it would have little economic impact and undermined savings needed to protect the country's rapidly ageing population.

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