UPDATE 4-ECB cuts rates to new low, no move on bolder measures

Thu Jul 5, 2012 11:21am EDT

* ECB cuts main rate by 25 bps as expected

* ECB cuts deposit rate to zero

* Draghi says euro zone to recover only gradually

* No signal more bond-buying or long-term liquidity imminent

By Marc Jones

FRANKFURT, July 5 (Reuters) - The European Central Bank cut interest rates to a record low on Thursday to breathe life into a deteriorating euro zone economy but steered clear of more dramatic measures such as buying government bonds or flooding banks with fresh liquidity.

The ECB policymakers' decision to cut their main refinancing rate by a quarter point to 0.75 percent was unanimous and followed a dire batch of economic data that show even euro zone powerhouse Germany is entering a modest downturn.

European shares extended gains on the decision before turning negative after ECB President Mario Draghi said the euro zone would recover only slowly, threatened by the debt woes of several of the bloc's members and banks' unwillingness to lend.

"The risks surrounding the economic outlook for the euro area continue to be on the downside," Draghi told a news conference, saying there was effectively no growth in the euro zone now.

"Beyond the short term, we expect the euro area economy to recover gradually, although with momentum dampened by a number of factors. In particular, tensions in some euro area sovereign debt markets and their impact on credit conditions."

The ECB's loosening of policy followed shortly after China and Britain did similar.

Draghi said there was no coordination between the three.

In addition to cutting the main refinancing rate, the ECB also reduced its deposit rate, which acts as a floor for the money market, to zero from 0.25 percent.

This move could encourage banks to lend to each other rather than simply parking funds of up to 800 billion euros back at the ECB every night, for which they will now get no return.

It will also be welcomed by the southern European banks that have tapped the ECB heavily for loans. A 25-basis-point cut would decrease annual interest payments from the 1 trillion euros in 3-year loans by about 2.5 billion euros.

The interest rate cut is not seen as a panacea for the euro zone's problems, which stem from a loss of confidence in state and bank finances, but the reduction in borrowing costs shows the ECB is ready to support the flagging economy.

"Today's ECB interest rate cut does little to alter the bleak economic outlook," said Jennifer McKeown at Capital Economics. "At least today's action is a sign of support."

"SPECIAL STRENGTH"

Draghi urged businesses to take confidence from the cut.

"It is encouraging, it should make entrepreneurs think their investment decision trade-offs are now improved, are now better," he said.

While inflation remains above the ECB's target of just below 2 percent, it has been sliding recently though Draghi said he saw no signs deflation in any euro zone country.

Of 71 economists polled by Reuters, 48 had expected the bank to cut, most of them by 25 basis points, though some others forecast a larger decrease.

Draghi said the decision was unanimous. "This carries a special strength," he said.

Despite the pressure of the euro zone crisis, Draghi said the economic and financial situation was not as bad as in 2008, when the collapse of Lehman Brothers bank sparked the global financial crisis.

"We are not there at all," he said. "The financial environment (is) nowadays a little less tense than it was a month ago."

"NON-STANDARD MEASURES"

The central bank had faced pressure from investors and the International Monetary Fund to take bolder measures, with IMF Managing Director Christine Lagarde urging the bank to resume its purchases of government bonds.

The ECB did not heed that advice. A core of its policymakers feel the bank's bond buying programme - dormant for four months now - amounts to monetary financing of governments, which is beyond the bank's mandate.

Draghi also gave no strong signal that the ECB was poised to offer a repeat of the twin 3-year ultra-cheap loans, or LTROs, with which it funnelled over 1 trillion euros to banks in December and February.

"We didn't discuss any other non-standard measures," he said.

The size of the twin LTROs offered in December and February meant their effect would take time to show up, said Draghi, though he did not rule out further such action.

"We always said that our non-standard measures are temporary, and we don't want to pre-commit about future decisions," he said. "But certainly now a few months have passed, and we see that credit flows are actually weak and remain weak."

While the ECB is not ready to announce that the bond programme is officially over, it has become clear that the purchases would be restarted only in an absolute emergency.

By contrast, easing price pressures gave the ECB plenty of cover to cut rates, backing up an EU summit deal last week when government leaders agreed to let the euro zone's rescue fund inject aid directly into banks and intervene on bond markets.

Draghi dismissed another crisis response option: allowing the ESM rescue fund to have access to the ECB's cheap loans - a scenario that would boost the ESM's firepower and allow it to intervene with real impact on bond markets, where Spain's benchmark yields are still well above 6 percent.

Asked if the ECB could boost the ESM, Draghi replied: "I don't think there is anything to gain in destroying the credibility of an institution, asking it to behave outside the limits of its mandates."

"Frankly, right now I think the ESM and the EFSF with the new modalities are enough, are adequate to cope with the risks that ... with the contingencies that we can envisage now."

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