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ECB in surprise rate cut to avert deflation

The European Central Bank surprised financial markets on Thursday (Sep 4) with a new cut in key interest rates and an asset purchase scheme to ward off deflation in the single currency area.

FRANKFURT: The European Central Bank surprised financial markets on Thursday (Sep 4) with a new cut in key interest rates and an asset purchase scheme to ward off deflation in the single currency area.

The news sent the euro down by more than a cent against the dollar to the lowest level for 13 months, and boosted European and US stocks.

Against a background of growing concern that the eurozone is on the verge of dangerous spiral of falling prices the ECB cut its central "refi" refinancing rate to 0.05 per cent from 0.15 per cent. It also lowered the deposit rate to minus 0.20 per cent from minus 0.10 per cent and trimmed its marginal lending rate to 0.30 per cent from 0.40 per cent.

Few analysts had expected any further rate action this month, arguing that, with eurozone borrowing costs already at record lows, a cut would not prove particularly effective. At a news conference to explain the reasoning behind the move, ECB chief Mario Draghi also unveiled plans to buy asset-backed securities (ABS) to help kick-start credit in the region.

But the measures would not stop there. "Should it become necessary to further address risks of too prolonged a period of low inflation, the governing council is unanimous in its commitment to using additional unconventional instruments within its mandate," Draghi told a news conference.

QE DISCUSSED

Many observers had expected the ECB to embark on a policy of what is known as "quantitative easing" or "QE", a radical policy - already used by other central banks such as the US Federal Reserve - of buying securities on a big scale to inject cash into the economy. Draghi said that such a programme had been discussed, but the governing council opted for a narrower ABS scheme instead.

Pressure has increased on the ECB to act after eurozone inflation slowed to just 0.3 per cent in August from 0.4 percent the previous month. The latest data puts inflation worryingly far below the central bank's target of just under 2.0 per cent and brings the single currency area perilously close to deflation. This is a climate of falling prices which can cause businesses and consumers to delay purchases, further reducing demand and prices and pushing up unemployment.

But there is resistance to QE because it would entail the ECB buying up sovereign bonds, which many critics - including the German central bank or Bundesbank - view as monetary financing, or printing money to pay a country's debt. The ECB is expressly forbidden from doing that.

NOT UNANIMOUS

Draghi revealed that both the decisions to cut rates and embark on an ABS scheme were "not unanimous." Nevertheless, the measures adopted were agreed by a "comfortable majority" on the decision-making governing council, Draghi said.

The moves became necessary as the growth and inflation outlook continues to cloud over for the euro area.

According to the ECB's own latest forecasts, gross domestic product (GDP) is expected to expand by 0.9 per cent in 2014 and 1.6 per cent in 2015. "Compared with our projections in June, the projections for real GDP growth for 2014 and 2015 have been revised downwards," Draghi said.

The bank said inflation was expected to be 0.6 per cent this year - a lower rate than the 0.7 originally forecast.

Inflation in the eurozone cannot be brought back up to target by means of monetary policy alone, and governments must also play their part with reforms, Draghi insisted. "It will be very difficult to reach an inflation target of close to 2.0 percent based on monetary policy. We need growth as well," Draghi said. "For doing that, you need other things, fiscal policy, structural reforms first and foremost." 

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