ECB Cuts Rates As Eurozone Braces For Possible Greek Exit

2011-11-03 17:06:38

The European Central Bank lowered its interest rates on Thursday in a surprise move as the possibility of Greece leaving the single currency block increases.

The Governing Council led by new ECB President Mario Draghi decided to lower the main refi rate to 1.25 percent from 1.50 percent.

The vote for easier monetary policy represents a break from the inflation-fighting stance favored by Draghi's predecessor Jean-Claude Trichet -- economists had expected the rate to be left unchanged in Draghi's inaugural rate-setting meeting.

The latest reduction comes after the bank held rates steady for three consecutive months. In July, the central bank had hiked the rate for a second time this year.

The marginal lending facility rate was cut to 2 percent from 2.25 percent, while the the deposit facility rate was slashed to 0.50 percent from 0.75 percent.

At a press conference explaining the unanimous decision, Draghi said he sees intensified downside risks the eurozone's economic outlook, and predicted that downward revisions to 2012 growth prediction are now likely.

Given the economic malaise, inflation rates should fall below the ECB's 2 percent target in 2012, according to Draghi.

"It is a relief that the ECB seems to have dropped its earlier concerns about phantom inflationary pressures," Capital Economics economist Jennifer McKeown said. "It is starting to acknowledge the effects of the region's debt crisis on the wider economy."

Draghi has sprung a surprise in his very first policy meeting. He was widely expected to leave the key interest rate unchanged, instead focus on ensuring continuity and projecting an image of stability in the eurozone.

The Italian policymaker has always maintained a low profile and hardly featured among the ECB hawks, ING Bank economist Carsten Brzeski said earlier this week. "Draghi will do all he can to ensure continuity of the ECB's monetary policy and also its communication," the economist added.

Draghi said that the ECB was keeping a close eye on developments in Greece, where embattled Prime Minister George Papandreou is expected to address the public in a speech tonight.

Even as it looked as if a crisis breakthrough was achieved last week, Papandreou wrong-footed the EU as he announced on Monday that a public referendum and a confidence vote will be held in the country over the new EU-IMF bailout.

The move created chaos within Greece and with the EU. The Greek government is on the verge of a collapse amid a split between the Premier and the finance minister over the referendum proposal.

The market turbulence caused by Greece and other profligate eurozone member is "likely to dampen the pace of economic growth in the second half of the year and beyond," Draghi warned.

Following an emergency meeting in Cannes ahead of the G20 summit today, the EU decided on Wednesday to block the payment of the latest loan tranche worth EUR 8 billion to Greece until the referendum, which is likely to be held on December 4.

German Chancellor Angela Merkel and French President Nicolas Sarkozy, who held talks with Papandreou, said Greece would not receive a "single cent" of aid if voters reject the plan. Eurogroup Chairman Jean-Claude Juncker said the referendum is entirely about whether the country will stay in the euro area or not.

Without external financial support, Greece is likely to run out of funds soon and default on its debt. The possibility of the country exiting the euro area, which was seen as a impossible event until last week, is formally recognized now.

EU leaders had agreed on October 27 to enhance the European Financial Stability Facility (EFSF) to EUR 1 trillion from EUR 440 billion and persuade private investors to bear 50 percent loss on their Greek holdings.

Investors are having no respite from increasing concerns over the crisis situation. Yesterday Italian bond yields rose to a euro-era records, while the euro bailout fund, the EFSF delayed a EUR 3 billion 10-year bond sale to fund Ireland's bailout due to volatile market conditions.

The new ECB chief is likely to face increasing opposition to ECB bond buying from within the Governing Council. The central bank's bond purchases totaled EUR 173.499 billion as on October 28.

Policymakers from Germany and the Netherlands have already voiced concerns over ECB's bond buying practice. However, the central bank is left with no option, but to act as the only backstop, until the reformed EFSF is operational.

"Our securities market program has three characteristics: it is temporary; it is limited; it is justified in restoring the functioning of monetary transmission channels," Draghi said.

The ECB says covered bond purchases will start this month and will be completed by the end of October 2012.

Meanwhile, the economic outlook for the 17-nation economy is increasingly turning bleak. Inflation held steady at a three-year high in October, above the central bank's 'below, but close to 2 percent' threshold.

Unemployment increased further in September. In Germany, the biggest economy in the region, jobless rose for the first time in nearly two years in October. Recent purchasing managers' surveys also did not give any reason to cheer.

Most economists say the Eurozone economy is on the brink of recession. Given such a scenario, some expect the ECB to signal a rate cut for early next year. Yesterday, the U.S. Federal Reserve trimmed its growth outlook while deciding to leave interest rates unchanged.

Early this week, the Organization for Economic Cooperation and Development cut its Eurozone growth forecast for this year and next to 1.6 percent and 0.3 percent, respectively. In May, the Paris-based think tank had forecast 2 percent growth each for these two years.