European Central Bank cuts key interest rates by a quarter point, taking benchmark rate down to to 1.25%

Cindy Allen

Cindy Allen

Nov 3, 2011 – Associated Press

FRANKFURT, Germany , November 3, 2011 () – The European Central Bank has cut interest rates by a quarter percentage point under new head Mario Draghi as it tries to boost a weakening economy that's reeling from a government debt crisis that threatens to spread from Greece.

The dramatic debut move from Draghi, which comes earlier than expected by many economists, takes the bank's benchmark rate to 1.25 percent.

European growth is expected to slow down in the last three months of the year, and the rate cut is aimed at preventing an outright recession. Uncertainty from Europe's debt crisis is a factor as business and consumers are reluctant to spend and investors are worried of the potential for more financial turmoil if Greece defaults on its debts.

The current market turbulence is "likely to dampen the pace of economic growth in the second half of the year and beyond," said Draghi at his post-meeting press conference. That, in turn, would lower the risk of inflation remaining high.

He signaled, however, that the ECB's bond purchases, which have been keeping down borrowing rates for financially weak countries like Italy, are temporary and limited.

Markets had hoped that Draghi would indicate the bank was willing to be more aggressive with the bond purchases.

But Draghi said it was up to governments to fix their finances. "It is pointless to think sovereign bond rates could be brought down for an extended period of time by outside interventions."

The euro fell sharply, from over $1.38 to below $.137, after the comments.

Markets will pin their hopes on the surprise interest rate cut to shore up confidence at a time when Europe is embroiled in a crisis stemming from Greek Prime Minister George Papandreou's pledge to hold a referendum on the country's latest bailout package.

That triggered fears of a disorderly Greek debt default and its possible exit from the euro. However, it looks like the referendum might not be held if Papandreou loses a confidence vote Friday.

"It is obvious that the ECB has caught the crisis virus and is trying everything it can to prevent a full-fledged recession," said economist Carsten Brzeski at ING.

The bank's key rate had stood at 1.5 percent after increases in April and July aimed at warding off inflation.

Since then the economic outlook has worsened significantly for the 17 countries that use the euro, leading many analysts to think the bank was leaning toward a rate cut. But many thought it would not come until December or earlier next year.

Inflation at an annual rate of 3.0 percent — well above the bank's goal of just under 2 percent — gave ammunition to those arguing for a delay. Rate cuts spur growth but can worsen inflation, and fighting inflation is the bank's chief mission.

But leading indicators on business confidence have been sending ominous signs about growth, and Draghi's predecessor Jean-Claude Trichet last month stressed the high level of uncertainty facing Europe's economy. Trichet's unwillingness to provide a clear sign about when rates might move was interpreted as an attempt to give his successor a free hand.

The purchases drive down the borrowing costs that Italy and Spain face in bond markets. High interest rates on borrowing drove Greece, Ireland and Portugal to take bailout loans from other eurozone governments and the International Monetary Fund.

Under Trichet's leadership, both he and Draghi, a former World Bank director, stressed that the program was temporary. They said that the new eurozone bailout fund needs to be ready to step up and take the purchases over. The fund won't finish arrangements to leverage its limited financial resources until next month at the earliest, however.

That has left the ECB as the last line of defense in the bond market — a position it has been uncomfortable holding. Trichet limited his comments on the program, and markets want to see if Draghi will open the door to more aggressive purchases.

Critics of bond purchases argue that they take pressure off politicians to get their budget deficits down.

The issue is pressing, with Italian bond yields at an elevated 6.3 percent. The ECB purchase program had driven them under 5 percent in August but fears of more turmoil in Greece, and a perception that Italy is not acting quickly to cut spending and improve growth have put more pressure on its bonds.

Some economists have argued that only the ECB can act quickly and forcefully enough to backstop troubled governments and contain the crisis. Europe's bailout fund is considered too small, at euro440 billion, despite proposals agreed last week by eurozone leaders to increase its financial firepower to euro1 trillion.

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