ECB cuts rates to new low after inflation tumble

By Paul Carrel

FRANKFURT (Reuters) - The European Central Bank cut interest rates to a new record low on Thursday, responding to a slump in inflation that has sparked fears the euro zone's economic recovery could stall.

The euro fell sharply in response while European shares and German government bond futures rose.

The 23-man Governing Council had faced intense market scrutiny in the run-up to Thursday's decision after a shock slump in euro zone inflation to 0.7 percent in October - far below the ECB target of just under 2 percent.

Calls from government ministers and industry - the loudest from Italy - for the ECB to loosen policy to help bring down the euro's exchange rate had also heaped pressure on the Council, though few analysts expected a move this month.

The ECB cut its main refinancing rate to 0.25 percent. It held the deposit rate it pays on bank deposits at 0.0 percent and cut its marginal lending facility - or emergency borrowing rate - to 0.75 percent from 1.00 percent.

"Deflationary risks and the stronger euro seem to have motivated the ECB's move. It is obvious that the ECB under president Draghi has become much more pro-active than under any of his predecessors," said ING economist Carsten Brzeski.

"Let's now wait for the press conference (at 1230 GMT) to see whether Draghi has more surprises to offer."

All but one of the 23 money market traders polled by Reuters this week expected the ECB to remain on hold at Thursday's meeting, pending a clearer view about where euro zone inflation is heading.

The euro EUR= slid more than 1 percent on the day to hit a seven-week low of $1.3356, down from around $1.3490 just before the ECB announcement.

Markets will be listening for any indication of whether the cut marks the end of the ECB's policy easing cycle and what it means for the ECB's forward guidance on interest rates.

Since July, the ECB has said it expects to keep its key rates "at present or lower levels" for an extended period.

Investors will also be alert to any signals that the ECB could offer banks another injection of liquidity with long-term loans, known as LTROs.

Prior to Thursday's meeting, three strains of thinking appeared to be running through the Council, people familiar with the internal debate said.

One group was content to keep open the option of another round of long-term loans to banks, another favoured an interest rate cut, while a third was prepared to sit this one out.

"Now that the policy rate is at the lower bound, it begs the question how the ECB will react next year if growth and inflation fail to materialize?" said Andrew Bosomworth, senior portfolio manager at PIMCO in Munich.

"While quantitative easing would be the next logical step, I think the politics of asset purchases and the bifurcation within the euro zone mean the deflationary threshold for QE will be much higher than in other countries conducting this experiment."

ECB rates and inflation http://link.reuters.com/juw29s

FRAGILE RECOVERY

The head of Italy's business lobby Confindustria said on Wednesday the country was in a worrying "situation of deflation".

Adding to the ECB's dilemma over how to support a fragile recovery is a fall in excess liquidity - cash beyond what lenders need to cover day-to-day operations - as banks repay 3-year ECB loans early before a health check next year.

These early repayments are expected to push interbank lending rates higher over time and the ECB has been considering pumping more liquidity into the system to offset this development.

In a Reuters poll last week, 44 out 59 analysts surveyed said the ECB would inject more liquidity, probably early next year. It could do so, for example, by launching another long-term refinancing operation (LTRO).

The cut in the main refinancing rate to 0.25 percent could potentially also slow the pace of LTRO repayments, as lower interest costs make it more attractive for banks to hold on to the loans for longer and invest them in higher-yielding assets. (Writing by Paul Carrel; Editing by Jeremy Gaunt)