Draghi cautious on recovery, says ECB ready to act

By Eva Taylor and Sakari Suoninen

FRANKFURT | Thu Sep 5, 2013 11:51am EDT

(Reuters) - The European Central Bank said on Thursday it was ready to cut interest rates or pump more money into the euro zone economy if needed to bring money market rates down and help the euro zone's "very, very green" recovery.

The bank left its key interest rate unchanged at 0.5 percent, as expected by all 60 economists polled by Reuters.

But ECB President Mario Draghi said the policymaking Governing Council did discuss a possible rate cut at its monthly meeting, partly due to concern about money market rates and the uncertain nature of the recovery.

"If money market developments were to be judged unwarranted in their impact on our assessment of medium-term inflation, then such an instrument should be considered," he told a news conference, stressing that the ECB has a downward bias on rates.

"We stand ready to act," he added.

The dollar rose to a six-week peak against the euro after Draghi's comments. But money markets shrugged off the ECB's latest efforts to halt the rise in bank-to-bank borrowing costs, with rates roughly were they were before Draghi spoke once the dust had settled.

An ECB statement said the bank would remain "particularly attentive" to the implications of shrinking excess liquidity in the euro area on its monetary policy stance.

The ECB shaved its forecast for euro zone growth next year to 1.0 percent from 1.1 percent in the June staff projection and said the 17-nation currency area's economy would contract by 0.4 percent this year, less than the 0.6 percent foreseen three months ago.

A recent run of stronger-than-expected economic data, combined with the prospect of the U.S. Federal Reserve unwinding its stimulus, has pushed up market rates despite the ECB's use of forward guidance on rates for the first time in July.

Draghi reaffirmed the ECB's commitment to keep interest rates at record lows for an "extended period" - a message that Nordea analyst Anders Svendsen expects should have more impact on markets in the coming months.

"In the near term, I think markets shouldn't underestimate the risk of a refi rate cut," Svendsen said.

"Over the course of the autumn, I think we'll see numbers stabilize and then I think markets will start listening to what Draghi actually says once more - and what he is saying is that he is in no way content about the recovery in the euro area."

Draghi said there had been a debate on a rate cut on Thursday, with some governors arguing that improving economic data made such a discussion unjustified while others said the recovery was too fragile to rule out such a move.

The Italian added that he was "very, very cautious about the recovery", and that "these shoots are still very, very green" - comments that suggest he personally is dovish on policy.

CONSTERNATION

A rise in forward market interest rates has already caused consternation among the bank's policymakers.

Draghi said money market conditions had been influenced by a gradual reduction in excess liquidity - money in the system beyond what the market needs - as banks repay long-term loans (LTROs) they took from the ECB in late 2011 and early 2012.

"We will remain particularly attentive to the implications that these developments may have for the stance of monetary policy," he said in a warning to money markets.

Market rates have continued to rise despite the warning and the ECB's July assurance - repeated in August - of long-term low interest rates.

Benchmark 10-year German bond yields hit an 18-month high above 2 percent ahead of the meeting of the ECB's policymaking Governing Council, due to an improving economic outlook.

Much of the market rate pressure is linked to the global impact of the Federal Reserve heading towards cutting back its stimulus program - a dominant factor in global finance.

But divergent nuances among policymakers on what the ECB's first stab at forward guidance actually meant has diluted its impact and analysts said the central bank's main challenge was to make it more credible instead of lowering interest rates.

Global Insight economist Howard Archer saw a "very real chance" of an ECB cut to 0.25 percent in the fourth quarter.

"The ECB could very well be prompted into action to counter a further rise in euro zone market rates, particularly if they spike up when the U.S. Federal Reserve starts to taper," he said.

"The ECB could also eventually cut interest rates if euro zone recovery stalls over the coming months or even if it fails to gather significant momentum, which is very possible."

(Writing by Paul Taylor and Paul Carrel; Editing by Jeremy Gaunt)