Sunday, January 4, 2009

Papademos Says ECB May Cut Rates If Inflation Slows (Update1)

By Scott Lanman and Simon Kennedy

Jan. 4 (Bloomberg) -- European Central Bank Vice President Lucas Papademos said further interest rate cuts may be necessary if inflation keeps slowing.

If price stability is threatened by weakening inflation “an easing of monetary policy could be warranted in order to keep inflation over the medium term at levels close to but below 2 percent,” Papademos said in a speech at a conference of economists in San Francisco today.

Having reduced the ECB’s key interest rate by 175 basis points since early October to 2.5 percent, the bank’s policy makers enter the New Year under pressure to cut more deeply amid Europe’s first recession in 15 years. A report scheduled for release next week will probably show inflation fell below the ECB’s target of just below 2 percent in December for the first time since July 2007.

While pledging that inflation would not be allowed to fall “significantly” below 2 percent for a protracted period, Papademos said any rate cut “to low levels must be judged with special care because of its longer term implications for price stability.” Similar comments from other officials have prompted some investors and economists to bet the ECB will leave its key rate unchanged when its governing council next convenes Jan. 15.

“The ECB will do what is necessary to ensure that medium- term inflation will be in line with our definition of price stability,” Papademos said.

‘Remain Weak’

The euro-area economy is likely to “remain weak” this year and may even contract in the first half, Papademos said. While inflation could “drop considerably” around the middle of the year, the risk of deflation is “nil,” he said.

The ECB last month predicted its 22-nation economy would contract about 0.5 percent this year, the first annual decline since the euro began trading a decade ago. Economists at Bank of American Corp. are among those anticipating an even weaker performance with a prediction for a 2.5 percent shrinkage.

Retail sales fell for a seventh month in December, manufacturing shrank at a record pace and lending to the private sector stagnated, reports showed in the past week. Data scheduled for release on Jan. 6 will show the inflation rate fell to 1.8 percent in December from 2.1 percent the previous month, according to the median of 20 forecasts given by economists.

Recent data confirm the economy faces downside risks, yet “do not suggest that the outlook for medium-term growth in the euro-area is likely to fall below the lower range” of the ECB’s forecasts, Papademos said. The foot of the ECB’s range of predictions is for the economy to contract 1 percent this year before growing 0.5 percent next year.

Defended the ECB

Papademos defended the ECB for not cutting interest rates quicker, arguing that inflation risks had been “on the upside and were increasing” until the middle of last summer. The bank’s willingness to then pare rates at the fastest pace in its history showed it had “responded in a timely manner to diminished inflation risks,” he said.

The financial crisis has resulted in a “growing recognition” that bank regulation needs to be strengthened and consolidated in the euro area, he said. In an interview published yesterday with Germany’s WirtschaftsWoche magazine, he said that may eventually mean the ECB and its network of regional central banks win new powers to supervise banks whose businesses spread across national borders.

“Enhancement of the current supervisory framework should be fully exploited,” he said today.

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