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Trichet Holds ECB Rates Steady but Softens Stance on Inflation

By , Money Morning •

By Jason Simpkins
Associate Editor

The European Central Bank (ECB) yesterday (Thursday) held its key interest rate steady at 4.25%, but ECB President Jean-Claude Trichet struck a much less hawkish tone in announcing the decision and may be forced to cut rates before year-end to revive the Eurozone's shrinking economy.

"Economic activity in the euro area is weakening with contracting domestic demand and tighter financing conditions," Trichet told a news conference. "With the weakening of demand, upside risks to price stability have diminished somewhat," he added, "but they have not disappeared."

The statement was a marked shift from the President's previously hawkish tone. Trichet had previously stated that he believes in a "clear separation" between monetary policy and liquidity management, and insisted that tight credit conditions could be balanced by cash injections and interest rates should only be tampered with as a means of controlling inflation.

The ECB is the only central bank in the Group of Seven to raise borrowing costs this year having raised its key interest rate by 25 basis points in July. The rate of inflation slowed to 3.8% in August, a drop of 0.2% from July, but the Eurozone economy contracted by 0.2% in the second quarter and most analysts believe the growth in the third quarter contracted as well.

Now, credit conditions have tightened significantly and liquidity injections have done little to restore confidence to the market.

The London Interbank Offered Rate (LIBOR), the overnight rate at which banks lend to each other rose for a fourth straight day yesterday to 4.21%  -- an indication that banks are still reluctant to lend to one another.

European governments have been forced to bailout five banks in the past week, despite liquidity measures taken by the ECB. 

"Liquidity injections are providing short-term relief but not a cure to a capital-starved banking system," Gareth Claase, an economist at Royal Bank of Scotland Group PLC (ADR: RBS) wrote in a research note. "The rapid deterioration in financing conditions, if it persists, has the potential to be very disruptive to the economy."

Trichet's comments roused speculation that the inflation hawk is now more willing to reduce rates, possibly at the next ECB meeting, scheduled for Nov. 11.

"Clearly there is a rather pronounced shift in the ECB stance that should pave the way to the central bank cutting rates," Aurielo Maccario, an economist at UniCredit SpA told Reuters. "The chances for a rate cut at the turn of the year are very high."

The euro fell to a one-year low against the dollar yesterday falling 1.8% to $1.3762 after Trichet's comments, the Financial Times reported. The European currency fell 1.8% against the Japanese yen.

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