ECB Cuts Rate to Fight ‘Prolonged’ Inflation Weakness

European Central Bank President Mario Draghi warned the euro area risks a “prolonged period” of low inflation as the bank cut its benchmark interest rate to a record.

Pledging to keep borrowing costs low for an “extended period,” Draghi said weakening price pressures justified the ECB’s surprise decision to cut its main refinancing rate today by a quarter point to 0.25 percent. Just three of 70 economists surveyed by Bloomberg News anticipated the action even after inflation faded to its slowest in four years.

“Our monetary policy stance will remain accommodative for as long as necessary,” Draghi told reporters in Frankfurt. Officials will provide more detail on the inflation outlook at next month’s meeting, he said.

The ECB now has just one more quarter-point cut left before its main rate reaches zero, increasing the likelihood of unconventional tools such as a negative deposit rate if prices slow further or the economic recovery stalls. Euro-area inflation is less than half the ECB’s ceiling and unemployment is at the highest level since the currency bloc was formed in 1999.

The ECB kept its deposit rate at zero and trimmed the marginal lending rate to 0.75 percent, allowing Draghi to say the ECB still had conventional policies to deploy if needed. The bank also will extend its unlimited offerings of one-month and three-month cash until the middle of 2015, he said.

Money Markets

“We continue to monitor closely money market conditions and their potential impact on our monetary policy stance,” Draghi said. “We are ready to consider all available instruments.”

The euro fell the most in almost two years versus the dollar, touching $1.3296, the lowest since Sept. 16. Euro-area government bonds rose, led by Italian and Spanish securities, with Germany’s two-year rate dropping to the least since July.

The ECB is among the central banks using so-called forward guidance in an effort to avoid market rates from rising too soon and to encourage consumers and companies to spend. On how long inflation may remain low, Draghi said today that officials will be “clearer on the length of time of this period in December.''

Draghi’s ECB sprang into action as the euro region’s economy shows signs of fragility. Unemployment is at 12.2 percent and the euro has climbed almost 5 percent against its major peers this year in a challenge to exporters.

Deflation Spiral

That’s sparked fears that the economy could slip into a deflationary cycle, angst that was fueled when a report last week showed inflation unexpectedly slowed in October to 0.7 percent. That compares with an ECB target of “close to but below” 2 percent.

“There comes a point where inflation is so weak, and coming in weaker than anticipated, that the case for loosening policy becomes too hard to resist,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London, who predicted the cut. “Bad unemployment numbers only make the case stronger.”

Beyond rate cuts and further liquidity measures, more expansive actions may still be harder to countenance. A Federal Reserve-style quantitative easing program has repeatedly been ruled out by ECB policy makers. The central bank is barred by European Union treaties from financing state debt, making large-scale purchases of government bonds open to a legal challenge.

While Draghi again floated the prospect of a negative deposit rate, the rate for commercial lenders who park excess cash at the central bank, officials have said that its effects can’t be adequately predicted.

Negative Rates

A negative deposit rate could hurt banks’ profitability by lowering money-market rates, potentially hampering credit supply to companies and households and reducing banks’ incentive to lend to other financial institutions.

Today’s decision aligns the ECB with other central banks in reinforcing rather than retracting loose monetary policy amid sluggish economic growth and soft inflation. The Fed decided in September not to taper its asset purchase program, while the Bank of Canada dropped language last month about the need for future rate increases. Emerging markets from Israel to Chile have cut borrowing costs since the start of September.

Taking Office

The unexpected nature of the rate cut underscores Draghi’s status as a central banker prepared to tackle head on the challenges facing the euro.

Since he took office almost exactly two years ago, Draghi has cut rates by a cumulative 1.25 percentage points, pumped unlimited quantities of three-year loans into the financial system and pledged to do “whatever it takes” to defend the euro. That announcement, in the teeth of criticism from some central bankers in Europe, helped draw a line under the region’s debt crisis.

“I have a huge amount of respect for the Draghi regime,” said Kit Juckes, global strategist at Societe Generale SA in London. “He is incredibly imaginative and innovative, even if he isn’t armed with big enough weapons.”

(Corrects third, eighth paragraphs to specify inflation rather than rate outlook. For more on Europe’s debt crisis, see TOP CRIS.)
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