Deflation fears were highlighted by ECB boss Wim Duisenberg
The European Central Bank has slashed interest rates in the 12-nation eurozone by half a percentage point to 2%, in the face of fears of deflation and renewed recession.
The decision marks a radical departure from the ECB’s usually cautious stance, but was widely predicted in Europe and elsewhere after the eurozone failed to grow at all during the first three months of the year.
Economists have pointed to recent statements by ECB President Wim Duisenberg, particularly at a central bankers’ conference earlier this week in Berlin, that inflation was set to fall “more significantly” in 2004.
“Joy at last,” said David Brown, chief economist at Bear Stearns in London.
“The ECB was getting well behind the curve in terms of what’s needed to re-stimulate recovery.”
The ECB’s brief is solely to fight inflation, but fears of deflation – where prices fall and the economy stagnates, as in Japan – have encouraged central bankers to seek bolder action.
The rapid strengthening of the value of the euro to almost $1.20 has also contributed to expectations of a hefty rate cut, in the hope of protecting European exporters by massaging the currency lower and making borrowing for investment cheaper.
The new level of 2%, as Mr Duisenberg pointed out at an afternoon news conference, is lower than at any time anywhere in Europe since World War II.
The euro rose 2% against the dollar following the decision, reaching $1.1888 in New York trade, before falling back to $1.1839.
European stock markets initially responded with vigour to the decision, with both France’s Cac 40 index and Germany’s Dax coming off earlier falls and heading towards positive territory.
But the rally was limited by concerns about the US economy as well as the fear that the ECB will now sit on its hands.
In the end, the Cac 40 closed down 29.78 points at 3,034, while the Dax ended 40.26 points lower at 3,039.76.
“The rate cut… was an imperative necessity. Now we are waiting for the comments to see if they will leave the door opened for further cuts,” said SocGen Euroland economist Veronique Riches-Flores.
“I don’t think they will and they probably made a big cut today to put an end to anticipation of new cuts.”
Earlier on Thursday, Sweden’s central bank cut its rates by half a percentage point to 3%.
But the UK’s Bank of England decided to stick fast, keeping UK rates at 3.75%.
Even though most forecasters had agreed that a 50 basis point (bp) cut was the best outcome, the ECB’s record of extreme caution had led many to fear a different outcome.
“Like many, we expect a 50bp cut, but the ECB is a proven master of disappointment,” Nomura economist Anais Faraj wrote on Thursday morning.
But in the event, the smoke signals emanating from Frankfurt turned out to be accurate.
“Duisenberg would not have been as forthright and clear if (Chief Economist Ottmar) Issing and (Vice-President Lucas) Papademos were not on board,” said Jonathan Hoffman, economist at RBS Financial Markets in London.