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ECB trims rates, edges into QE with bank bond buy

FRANKFURT (Reuters) - The European Central Bank said it will buy up bonds for the first time and trimmed its main interest rate to a record low on Thursday in a bid to stem the euro zone’s economic decline and shore up shaky markets.

Jean-Claude Trichet, President of the European Central Bank (ECB) arrives for his monthly news conference at the ECB headquarters in Frankfurt May 7, 2009. REUTERS/Johannes Eisele

The decision is the first step on a path of quantitative easing, although the ECB stopped short of the massive asset purchase programs followed by counterparts including the U.S. Federal Reserve and the Bank of England.

The ECB plans to spend about 60 billion euros ($80 billion) buying covered bank bonds -- securities issued by banks and backed by mortgages or other loans -- but did not rule out expanding into other types of assets.

As well, the ECB will double the maximum term of its loans to banks to 12 months and prolong easier rules on the types of assets which can be used as security in a three-pronged package of steps to complement its rate loosening.

The ECB has cut rates seven times in eight months, taking its main refinancing rate down another 25 basis points to 1.0 percent on Thursday in a move widely expected by financial markets, but leaving its lowest policy rate short of zero at 0.25 percent.

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ECB President Jean-Claude Trichet said the current level of rates was “appropriate” but left open the option of further cuts despite some policymakers arguing for a halt at 1 percent.

“We have not decided today that the new level of our policy rates was the lowest level, that we could never cross whatever future circumstances could be,” Trichet told a news conference after the decision.

Germany’s Axel Weber, one of the most vociferous in favor of a 1 percent limit, told German television that talk of further cuts was just speculation.

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Trichet also declined to commit the ECB to keep rates low for any set time, although economists polled by Reuters after the decision expect no change from 1 percent before 2011 at the earliest.

But it was the ECB’s decision to buy covered bonds which stole the limelight. Coming after months of deliberation and public disagreement among its 22 policymakers about how far to go to support growth, the decision pushed the euro to a fresh one-month high against the dollar.

Euro zone government bond futures fell to 5-1/2-month lows and the two/10-year yield curve steepened to a euro lifetime high on the decision, which Trichet said was unanimous, like all other resolutions at the May meeting.

“This is clearly a very welcome step,” said UniCredit economist Aurelio Maccario. “The ECB is ... providing relief to the banking system that, in turn, should mean rebirth of these markets and more possibilities to extend medium-to-long-term financing to the real economy.”

Thomson Reuters data puts the value of euro-denominated covered bonds still to mature at 917 billion euros, with Germany the biggest issuer, followed by Spain and then France.

Trichet did not explain how the purchases would be financed or conducted, saying technicalities would be hammered out at the next ECB meeting on June 4.

NOT QUANTITATIVE EASING

Key to the impact of the move will be whether the ECB neutralizes the purchases by issuing IOUs to mop up the extra liquidity created, a step ECB Executive Board member Lorenzo Bini Smaghi said last week was legally possible.

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Asked if the purchases would be sterilized, Trichet said sterilization and an exit strategy were essential, without giving further details.

“We are not at all embarking on quantitative easing,” he said, insisting the steps were aimed at supporting a market hard hit by the financial market crisis.

Almost two-thirds of economists in a Reuters poll said 60 billion euros was “about right,” while the rest said it was not enough.

Barclays Capital economist Julian Callow said the spend was fairly small, but could pave the way for more purchases later.

“Clearly this ‘credit easing’ could start to open the door for fully fledged QE from the summer, if the inflation outlook were to become more negative,” Callow said.

The ECB’s pledge also pales compared to other central banks. The Fed is spending $100 billion on mortgage-backed securities alone and up to $300 billion on Treasuries, while BoE policymakers on Thursday said they would increase spending on their debt purchase plan to 125 billion pounds ($189.5 billion).

Trichet said the euro zone and the world economy were still in the midst of a severe downturn. The euro zone economy would likely shrink in the first quarter even more than the ECB had expected and although the second would probably show some improvement, signs of new growth were still tentative.

“We were in a free fall, but now we see there is a stabilization. As I said, we have to be realistic, it is a stabilization at a low level and we continue to be in negative territory,” Trichet said.

“It depends on our capacity to improve the level of confidence of all economic agents that these green shoots will be greener and greener.”

Trichet said ECB staff would revise their forecasts down in June to roughly in line with the 4 percent contraction seen this year by the European Commission and the 4.2 percent fall forecast by the International Monetary Fund.

In a further announcement, the European Investment Bank will also be allowed to join commercial banks in tapping ECB funds at liquidity operations, helping to support the extra demand for EIB funds.

The EIB, the 27-nation EU’s financing arm, has become a tool to help the bloc overcome the worst recession in decades and is lending money to countries including Estonia as well as the struggling European auto industry.

Writing by Krista Hughes and Marc Jones; editing by David Stamp, Ron Askew and James Dalgleish

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