ECB cuts rates to 0.25% to stave off deflation risk

The European Central Bank surprised markets by cutting its benchmark interest rate to a record low this week, moving more quickly than expected to stimulate the eurozone economy amid falling inflation.

The ECB cut its main rate to 0.25 per cent from 0.5 per cent, which was already a record low.

Eurozone inflation fell to an annual 0.7 per cent in October, much lower than the ECB's official target of about 2 er cent. The fall raised the spectre of deflation - a sustained fall in prices that can destroy the profits of companies and the jobs they provide.

Many economists and political leaders will applaud the decision, which is likely to weaken the euro against the dollar and help European exporters. European stocks were mixed on the news, with exchanges in Paris and Frankfurt initially up more than 1 per cent and then falling flat, while the euro fell more than 1 per cent against the US dollar. A cheaper euro makes European products less expensive abroad.

But the decision carries some risks. It could be interpreted to mean the ECB is more concerned about deflation and slow growth than analysts expected, undermining confidence. And the 0.25 per cent cut leaves the bank with little room to manoeuvre if conditions worsen.

"Deflationary risks and the stronger euro seem to have motivated the ECB move," Carsten Brzeski, an analyst at ING, said in a note to clients. "It is obvious that the ECB under President [Mario] Draghi has become much more proactive than under any of his predecessors."

The bank's prime mandate is to defend price stability. But most analysts expected the ECB to wait until December to act, once there was more economic data available.

Mr Draghi said interest rates would stay low for an extended period of time. The central bank would also keep supplying banks with cheap loans until mid-2015. But the eurozone was not in a period of Japan-style deflation, he said. On the contrary, price declines in some countries were welcome because they would be more competitive on international markets.

Some economists have argued that falling inflation, coming after five years of recession or very slow growth, means that the eurozone faces an acute risk of deflation. While lower prices might seem like a good thing for consumers, in fact deflation is considered even more dangerous than runaway inflation.

When prices fall, consumers and businesses delay purchases, because they expect goods to become even cheaper. Corporate profits decline, and companies are forced to pay their workers less. A spiral begins that is difficult to arrest.

Deflation could be particularly destructive in Europe, where governments, banks and private households are struggling with excess debt. When companies and individuals earn less, they have trouble repaying their debts, which remain the same.

It is unclear, though, what effect the rate cut will have, given that market interest rates are already effectively less than zero. At best, the cut signals that the ECB will remain true to its mission of ensuring stable prices.

The view in Germany and among some economists is that there is no threat of deflation. This group sees slowing inflation merely as a sign that wages are falling in countries like Spain and Greece, where labour costs had become too high for companies to compete in the international marketplace.

It is likely Jens Weidmann, president of the German central bank and a member of the ECB governing council, argued against a rate cut.

Although the eurozone emerged from recession this year, recent economic indicators have sent conflicting signals about the strength of the recovery. Few economists expect a strong rebound but some have been more pessimistic than others, warning of long-term stagnation if the ECB does not do more to stimulate lending and growth.

"There has been a big hoo-ha about this very modest return to growth," said Simon Tilford, deputy director of the Centre for European Reform in London. "Clearly the risks are mounting."

In contrast to the ECB's move, Britain's central bank kept its benchmark interest rate unchanged Thursday at a record low of 0.5 per cent amid signs that the country's recovery was gaining speed.

In the US, the government said the economy had grown at an annual rate of 2.8 per cent in the third quarter, significantly better than economists had expected and the fastest pace this year.