ECB trims rates, to announce any alternative steps

The European Central Bank cut its main interest rate on Thursday to 1.0 percent, and financial markets are now focused on any alternative policy measures the ECB reveals to get the euro zone economy back on its feet.

The ECB lowered the refi rate by a quarter percentage point, and economists will await any comments by President Jean-Claude Trichet at his 1230 GMT news conference on whether it has reached a floor or still has room to go lower.

However, the ECB kept the overnight deposit rate, which is acting as a floor for money markets, at 0.25 percent, narrowing the gap between its policy rates instead of cutting the lowest of these to zero. The marginal lending rate was cut by 50 basis points, to 1.75 percent.

The rate decision was no surprise, but it is all about the language that will go with it, said Royal Bank of Scotland economist Jacques Cailloux. The question is whether they will provide indication if the door remains open for further cuts or whether they close the door entirely.

There is a strong feeling that this was the final cut in a cycle where the Governing Council has slashed the refi rate from 4.25 percent since last October. (For graph, click http://graphics.thomsonreuters.com/RNGS/MAY/RATE.jpg)

The euro rose against the U.S. dollar to $1.336 at 1150 GMT and government bond futures inched lower.

Several policymakers have said they are unwilling to go below 1 percent for practical and psychological reasons. Attention is now turning to the ECB's stance on extra steps, such as the asset purchases adopted by other central banks.

Analysts polled by Reuters were unanimous that the ECB would cut rates by 25 basis points to a fresh record low. Most of them expect the ECB to have reached the rate floor after Thursday's move.

SPLIT

Trichet has promised to reveal at the news conference what, if any, further unconventional tactics the ECB will use. Judging by recent public comments, policymakers were split on what to do before the meeting started.

Comments from some, including Axel Weber and Juergen Stark, suggest that the ECB is likely to double the maximum period that commercial banks can borrow funds to 12 months.

Weber, who heads Germany's Bundesbank, has also suggested that any move on extending loan maturities should come with a guarantee that interest rates will not be cut further.

Other ECB members, including Vice-President Lucas Papademos and Athanasios Orphanides, have floated a bolder approach of buying assets such as bank bonds or commercial paper.

Economists are equally divided on the ECB's likely path.

Cailloux said the deteriorating economy warranted low rates, and added that if the ECB does not want to cut further, it should do something else to boost the economy.

We can accept that the central bank decides 1 percent is the floor, but they need to recognize that they have to provide additional measures, he said. You need to increase liquidity in the system, and to me, asset purchase is the answer.

He added that slow credit growth boosted the chances of the ECB deciding to start asset purchases.

Others think the bank will shy away from such a big step, at least for now. Although some ECB board members have advocated the buying of corporate bonds or commercial paper, some national central banks are skeptical. The mixed experience of the Bank of England boosts the arguments of the latter group, said Nomura analyst Laurent Bilke.

Some analysts expect something in between, with the ECB extending its lending maturities but striking a compromise by building in the option to buy assets if the economy worsens.

Although the Governing Council will not rule out the option (of asset purchases), buying private sector debt securities seems to be regarded as a plan B, said Fortis bank economist Nick Kounis.

Analysts in a Reuters poll last week saw a 60 percent chance of the ECB starting quantitative easing in the next months.

Bank of England policymakers left UK rates unchanged at 0.5 percent earlier on Thursday, as expected, and increased the size of their asset purchase program.

GREEN SHOOTS

Economists will also be scour Trichet's comments for hints that the ECB has spotted any green shoots of economic recovery. Policymakers in the U.S. and Britain have tentatively flagged such signs.

Better-than-expected euro zone business and consumer sentiment this month, alongside improvements in closely-watched forward-looking indicators such as PMI and business activity data have sparked hopes that the worst of the recession is over.

But the European Commission this week predicted the euro zone economy would shrink 4 percent this year and 0.1 percent next year, well below the ECB's current worst-case scenarios.

Such contraction eases any inflation expectations, and should give the ECB time before having to worry about pressures for price pressures to solidify.