ECB cuts key rate a quarter point to help economy

December 8, 2011 - 8:55 AM

FRANKFURT, Germany (AP) — The European Central Bank has cut its key interest rate by a quarter percentage point to 1.0 percent to help the eurozone economy as it slides toward recession because of the debt crisis.

The bank last cut rates only five weeks ago, on Nov. 3.

The cut was an aggressive move from the new ECB head, who took office Nov. 1. Under predecessor Jean-Claude Trichet, the bank sometimes moved more slowly than markets wanted on rate cuts, and even raised rates twice earlier this year on concerns about inflation.

Draghi has said the eurozone economy could be heading for a mild recession. The cut will promote economic growth and business optimism that policymakers are tackling the crisis.

A slowing economy would only make it harder for European governments to pay down debt.

Markets will now await the full ECB statement and President Mario Draghi's press conference. His comments will be studied closely for any signs that the ECB is preparing to buy more government bonds or take other aggressive action to help stabilize Europe's debt crisis.

Draghi hinted in a speech last week that further bond purchases were possible if Europe's leaders can come up with a credible plan to enforce budget discipline among the 17 countries that use the euro. That is the goal of an EU summit in Brussels that begins Thursday evening.

Large-scale bond purchases would help drive down government borrowing costs, which have risen to crippling levels in Italy and Spain, Europe's third- and fourth-largest economies.

By stabilizing the finances of Europe's governments, the ECB would strengthen the continent's financial system. European commercial banks that own government bonds face potentially huge losses and, as a result, they have curtailed lending to each other, banks and consumers. That credit squeeze is felt globally.

Yet even a broad agreement to reduce debt and to have the ECB intervene aggressively wouldn't fix deeper problems in the eurozone: anemic growth and high unemployment in some countries and long-term trade deficits.

Throughout the Great Recession, the ECB never lowered its target rate below 1 percent. By comparison, the U.S. Federal Reserve's target for short-term rates is 0-0.25 percent and the Bank of England's 0.5 percent.

The ECB raised rates twice earlier this year, in April and July, under former President Jean-Claude Trichet. It cut rates at Draghi's first policy meeting Nov. 3.

Lower rates are intended to stimulate growth by making it cheaper for businesses and consumers to borrow and spend. In the third quarter, economic growth in the eurozone was a meager 0.2 percent. Many economists believe the region's economy will shrink in the fourth quarter.

Lower interest rates can also push prices and wages higher. The fear of stoking inflation was a major reason why the ECB had been cautious about lowering rates earlier this year. But many economists say that with Europe likely headed for a mild recession, and possibly worse, the greater danger on the horizon is deflation, or falling prices and wages.

The inflation rate in Europe stands at 3.0 percent. That's above the bank's stated goal of just under 2 percent. But the bank forecasts it will fall in coming months.

Even more than the fear of inflation, the main factor holding back stepped-up bond purchases by the ECB is worry that the pressure on governments to enforce budgetary discipline would then fade.

On Dec. 1, Draghi urged European leaders to agree on "a fiscal compact" that would prevent eurozone governments from piling up too much debt and punish violators.

He then said: "Other elements might follow, but the sequencing matters."

Markets seized on that to mean that the central bank was ready to get more aggressive in fighting the debt crisis.

The ECB has several options to intervene more forcefully. It could:

— Explicitly tell markets that it won't permit Italian and Spanish bond yields to rise above, say, 5 percent. The central bank would then buy bonds until the yields fall to that level.

— Ramp up its purchases without an announcement and let the markets take notice.

— Issue a more vague statement that it stands ready to support governments.

— Work alone, or with other central banks, to lend to the International Monetary Fund, which could then help expand the size of Europe's bailout fund.

Not everyone is convinced financial markets are interpreting Draghi's comments accurately. "I think the market got carried away in interpreting this as a strong hint that the ECB will step up buying" of government bonds, said Stefan Schneider, chief international economist at Deutsche Bank.

Schneider said that if Europe's leaders reach a convincing agreement in Brussels, private investors might start buying bonds on a large enough scale to drive down government borrowing costs.

Since Europe's debt crisis erupted in 2008, the ECB has let banks borrow any amount they want for set periods. It has also made limited purchases of government bonds.

The ECB's main decision-making body is a 23-member governing council, chaired by Draghi. It is made up of the top central banker from each of the 17 countries that use the euro, plus a six-member executive committee that manages the bank's business at its Frankfurt headquarters.

Two members of the ECB's executive board will be leaving at the end of the year. Both were known for their anti-inflation stances.