September 27, 2011 / 1:57 AM / in 6 years

Options open on ECB rate cut, October talk "wild"

<p>A cyclist rides past the European Central Bank (ECB) headquarters in Frankfurt, August 4, 2011. REUTERS/Ralph Orlowski</p>

WASHINGTON/FRANKFURT (Reuters) - European Central Bank officials said on Monday they were keeping their options for a rate cut open, lifting markets, even as Luxembourg’s Yves Mersch warned speculation of a sharp move next month was “wild.”

European stock markets surged on the idea the bank could slash its 1.5 percent main rate by a half-point on October 6.

There are substantial barriers to it doing so, however. Not least that the meeting would conclude ECB President Jean-Claude Trichet’s term of office with a dramatic U-turn.

“These wild expectations only show that some people have lost the north,” Mersch told news agency Market News International in an interview conducted on Saturday, when asked about interest rates. “We have one needle in our compass.”

The last phrase is often used by ECB policymakers to refer to them abiding by the bank’s mandate of keeping inflation below 2 percent.

Euro zone inflation stood at 2.5 percent in August although it is expected to drop off over the policy horizon the bank uses to guide rate decisions.

In an interview with German daily Boersen-Zeitung published later, Mersch said rate cuts could be considered if the economic situation worsened considerably more than expected.

“Interest rate cuts are not completely ruled out,” he was quoted as saying. “Should there be, compared with current data, a significant worsening of the dynamics of the economy in the euro zone, we do have room to move.”

Finnish ECB policymaker Erkki Liikanen suggested that deterioration may already be happening.

“We said (in the last meeting) risks to inflation are balanced and risks to growth are to the downside. And my personal opinion is that the risks to growth are substantially to the downside,” he said at an Atlantic Council discussion when asked if the bank could cut rates next week.

Jens Weidmann, the head of Germany’s Bundesbank, was not so downbeat, however, saying German growth was expected to be a respectable 0.5 percent in Q3, and that while it would slow in Q4 and Q1 of next year, it should be a soft patch rather than anything more menacing.

He hit out again at pushing the ECB beyond its boundaries, warning that acting pre-emptively could deincentivise politicians to take action needed to solve the debt crisis.

“With all our actions we set incentives for politicians. If I tell a politician, hey, take our balance sheet to leverage your assets, I can be sure that there will be no further measures.” he said.

LIQUIDITY

There were also further signals that the ECB is set to start offering 12-month, limit-free loans to banks again, to help those struggling with their fund-raising.

“On the liquidity side in Europe the ECB’s position is very clear, if the banks have collateral we will give them liquidity,” said Liikanen.

“During the crisis we went to long operations... three-month, six-month and even 12-months, we prolonged them, so that is still in our tool box.”

Austrian central bank chief Ewald Nowotny mirrored those comments and he also left the door open to a cut in headline rates -- although his language used neutral wording officials often use to avoid giving a clear steer and gave no indication of timing.

“The ECB never pre-commits, and rate cuts cannot be excluded,” he said. “It all depends on the developments ahead.”

In a panel discussion in New York, Athanasios Orphanides, head of the central bank of Cyprus, called rates ”appropriately accommodative,“ while ECB Board member Lorenzo Bini Smaghi said it was good to leave some ”room for maneuver.

BOND STRATEGIES

In reference to plans for a more powerful euro zone bailout fund, Bini Smaghi said officials had already begun discussing the next steps they would take to quell the crisis.

Nowotny suggested it may not be as big as markets had been hoping, saying estimates of 1 trillion euros was probably too high. [nS1E78P1PM]

Mersch, meanwhile, said the ECB would do whatever it takes to keep money markets functioning properly, echoing the bank’s readiness to reintroduce more of the emergency steps it took to help banks after the 2008 crisis.

Bloomberg also reported, citing unnamed central bank sources, that the ECB is pondering buying mortgage-related covered bonds again, as it did from June 2009 to June 2010 when it spent 60 billion euros. The ECB would not comment on the report.

BARRIERS

Weidmann, one of the most anti to the ECB’s government bond purchases, warned against using the ECB in plans to boost the bailout fund.

“A bazooka! (a massively beefed up bailout fund that could tap the ECB) I don’t think it is a recipe that works in Europe,” Weidmann, a former close aide of German Chancellor Angela Merkel, said.

“This is a very dangerous thing. It means you completely blur the responsibility between fiscal and monetary policy.”

While the ECB appears united on the bailout fund issues, analysts said the differing tone of public comments suggested an unusual divide over where to go with interest rates.

One major barrier to a rate cut could be the ECB’s change of guard. As Liikanen noted, Trichet’s eight-year term at the helm of the 17-country bloc’s central bank ends next month, and reversing the interest rate increases could be seen as an admission that he made a big mistake.

“I think this is one of those situations where genuinely the Council will meet and review data that are coming up,” Societe General economist James Nixon said.

“I think that more so probably than at any other time in the ECB history, this is a situation where it probably will come down to a harsh vote.”

Additional reporting by Sakari Suoninen and Sylvia Westall in Vienna, Ros Krasny is Boston, Emily Flitter in New York; Editing by Ramya Venugopal

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