June 15, 2012 / 9:25 AM / 8 years ago

UPDATE 2-ECB's Draghi flags euro risks, spurs rate cut talk

By Eva Kuehnen and Marc Jones

FRANKFURT, June 15 (Reuters) - The euro zone economy faces serious risks and no inflation threat, European Central Bank President Mario Draghi said on Friday in comments that heightened expectations the ECB could cut interest rates or take other policy action soon.

Draghi also said the ECB stood ready to provide further liquidity to solvent banks, stressing that its provision of ultra-cheap 3-year funds, or LTROs, late in 2011 and early this year had averted a major credit crunch.

Financial markets are looking to the ECB to take the fast and decisive action the euro zone’s governments have been unable to muster to tackle the bloc’s crisis, which risks spiralling to a new intensity after knife-edge Greek elections on Sunday.

“There are serious downside risks here,” Draghi told the annual ECB Watchers conference in Frankfurt. “This risk has to do mostly with the heightened uncertainty.”

There had been a string of negative data since the May 24 cut-off period for the ECB’s latest staff projections, which pointed to the economic situation stabilising, Draghi said.

His comments came just days after other ECB policymakers said the central bank might be open to cutting interest rates.

The ECB left its main interest rate at 1 percent last week. Draghi’s comments on Friday reinforced economists’ expectations for the bank to cut rates soon.

“Everything is really pointing to a rate cut, even irrespective of what happens in Greece this Sunday,” said Berenberg Bank economist Christian Schulz.

“Obviously, if the Greeks commit economic suicide then the ECB’s reaction will be a lot stronger and then the rate cut would not just be the 25 basis points that are likely now but potentially also more LTROs and - in the very worst case, and probably not at the July meeting - if things don’t settle down after that, it could even be back to bond purchasing,” he added.

Authorities in Europe have laid plans for managing the damage if, for instance, a decisive victory on Sunday for the SYRIZA party, which has promised to tear up Greece’s bailout deal, prompted Greeks to empty their bank accounts.

Draghi said the Eurosystem of euro zone central banks would “continue to supply liquidity to solvent banks where needed.”

Another ECB policymaker, Executive Board member Peter Praet, said the ECB’s crisis measures, such as the LTROs, could continue to help the situation and stressed that they were not fuelling inflation - the traditional fear of euro zone paymaster Germany.

Draghi said: “The ECB has the crucial role of providing liquidity to sound bank counterparties in return for adequate collateral. This is what we have done throughout the crisis, faithful to our mandate of maintaining price stability over the medium term - and this is what we will continue to do.”

Newedge Strategy said in a research note: “The ECB seems to prepare the ground for further action near term. However, the move seems to be conditional on more ‘harmonisation’ across the euro area.”

The Euribor futures contract for July <FEIN2 > rallied 5 ticks on the day to its highest level in a week. The rally indicates traders are lowering their expectations of where Euribor rates, correlated with the ECB’s refinancing rate, will be next month when the contract expires.

Draghi kept the onus on politicians to stop the crisis spiralling, saying: “We have reached a contingency where political choices have become predominant over monetary instruments that we can use in the near future.”

He spoke after other central banks from major economies said they stood ready to take steps, including coordinated action, to stabilise markets as world economies prepare for a possible financial storm or public panic after the Greek vote.

Draghi added said inflation expectations were well anchored and “there is no inflation risk in any euro area country.”

ECB policymaker Ewald Nowotny said on Friday the bank has the ability to cut interest rates if the euro zone economy continues to deteriorate and could even slash the rate that controls money market rates to zero.

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