Economic gloom seen pushing ECB to cut rates

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The European Central Bank is widely expected to cut borrowing costs to a record low on Thursday to support a deteriorating eurozone economy and complement measures agreed by government leaders last week to tackle the bloc's debt crisis.

Economic surveys released on Wednesday suggested even eurozone powerhouse Germany is entering a modest downturn and investors want the ECB to take action. The consensus forecast is for a 1/4-percentage point cut in its main interest rate.

The ECB's policymaking Governing Council began meeting at 7 am GMT, with financial markets steady ahead of the decision on interest rates, which the bank will announce at 11.45 am GMT. ECB president Mario Draghi then holds a news conference at 12.30 pm GMT.

The central bank is under pressure from investors and even the International Monetary Fund to take bold measures, with IMF managing director Christine Lagarde urging the bank to resume its purchases of government bonds - an unlikely scenario.

The ECB's main refinancing rate is already at a record low of 1.0 per cent, and 48 of 71 economists in a Reuters poll expect the bank to cut it further, most of them by 25 basis points to 0.75 per cent. Some others see a larger decrease.

An interest rate cut is not seen as a panacea for the eurozone's problems, which stem from a loss of confidence in state and bank finances, but a reduction in borrowing costs would show the ECB is ready to breathe life into the flagging economy.

"It's not so much about the real effect that (a rate cut) will have," said Nordea analyst Aurelija Augulyte. "It's more a psychological game, a game of trying to be supportive of sentiment."

There is only a slim chance the ECB will offer a repeat of the twin 3-year ultra-cheap loans with which it funnelled over 1 trillion euros to banks in December and February.

But the ECB could cut the deposit rate it pays banks for parking money with it overnight and which acts as a floor for the money market.

IMF ADVICE

The IMF on Tuesday publicly questioned the wisdom of cutting rates further and urged the ECB to buy the bonds of distressed eurozone countries.

ECB policymakers are unlikely to heed this advice, however, with Executive Board member Peter Praet having offered the clearest signal that the bank will cut rates.

"There is no doctrine that interest rates cannot fall below 1 per cent," he said on June 27. Rate cuts 'are justified if they contribute to guaranteeing price stability in the medium term'.

Furthermore, a core of ECB policymakers feel the bank's bond buying programme - dormant for four months - amounts to monetary financing of governments, which is beyond the ECB mandate.

Easing price pressures give the ECB far clearer cover to cut interest rates, backing up the 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.

While inflation remains above the ECB's target of just below 2 per cent, it has been sliding recently and ECB staff expect it to average 1.6 per cent next year, giving room for a rate cut.

Business surveys released on Wednesday strengthened the case for a cut, showing the eurozone's private sector downturn eased only slightly in June and that it remains in recessionary territory.

A cut would 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.

"Given the banks' reliance on (such) funds, that will produce a very immediate injection into the financial system," Lena Komileva at G+ Economics said.

DEPOSIT RATE

In addition to the main refinancing rate, analysts are eager to see whether, and by how much, the ECB cuts its deposit rate, which acts as a floor for the money market.

A cut to as low as zero - from 0.25 per cent now - 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.

However, a deposit rate of zero could hamper the functioning of the money market as costs would exceed returns.

And, even with the deposit rate at zero, "good banks don't want to lend to insolvent banks," Nordea's Augulyte said, adding she expected a 15 basis point cut, to 0.1 per cent.

In a Reuters poll, money market traders were evenly split between cutting and holding the rate.

The ECB is unlikely to announce any further 'non-standard measures' - bond purchases or ultra-long loans - after already loosening its lending rules on June 22. It will want to see the impact of that step before tweaking the framework.

ECB President Mario Draghi will be quizzed on how firm the central bank's opposition is to reactivating its bond buy programme, and whether it could change its mind regarding giving the ESM bailout fund the option to tap ECB funds.

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

"The bond buying programme is in a deep sleep, and it will remain there," ECB governing council member Klaas Knot said in a magazine interview released on Wednesday.

Less clear is what Draghi will say about giving the euro zone's ESM permanent bailout fund a banking licence, which would allow it to exponentially increase its firepower from the planned 500 billion euros.

Some analysts see the ECB changing its course on ESM as the best option to quell the debt crisis.

"I think it's easier for the ECB and the Bundesbank to change their minds regarding the ESM than to reactivate the SMP programme," said Natixis economist Sylvain Broyer.

"We will at some point have to buy sovereign debt en masse, and it would be cleverer to let the ESM do it."