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ECB Rate Cut Just Became Even More Likely

ECB headquarters in Frankfurt am Main, Germany.
Getty Images
ECB headquarters in Frankfurt am Main, Germany.

The odds of a rate cut by the European Central Bank (ECB) increased significantly on Tuesday after euro zone inflation eased to 1.2 percent in April, the lowest level since February 2010.

To give you an idea of just how important that number is,economists were expecting inflation of 1.6 percent and the reading for March was 1.7 percent. The ECB's own inflation target is 2 percent.

So when ECB policymakers gather in Bratislava on Thursday, inflation is going to be furthest from their minds.

(Read More: Inflation Fall, Joblessness Point to ECB Rate Cut)

Instead, record unemployment in the euro zone could refocus attention on the region's recession. The unemployment rate in the single currency zone is now at a record 12.1 percent and 19.2 million people are out of work, the highest number since the creation of the euro in 1999.

Youth unemployment rates look scary, with 59.1 percent of Greeks under the age of 25 unemployed, while 55.9 percent of young Spaniards are without work.

"Latest comments by a number of senior ECB officials indicate that an interest rate cut is very much on the cards for Thursday, and we think the bank is more likely than not to act. If the ECB does hold fire on interest rates next Thursday, it is very likely only delaying the inevitable," Howard Archer, chief U.K. and European economist at IHS Global Insight wrote after Tuesday's data release.

Already, there are fears that southern Europe's recession is spreading north. In a poll by Reuters, 43 of 76 economists said they expected the central bank to cut rates by 25 basis points to a new record low of 0.5 percent.

(Read More: Spain's Economic Siesta Continues)

But according to asset manager Coutts, cutting rates alone won't be enough and the ECB should pump money into the economy via a TARP (Troubled Asset Relief Program)-like scheme. That program was created by the U.S. government in an attempt to stem the financial crisis.

"Non-functioning banking systems are the issue, rather than an absence of liquidity. So for ECB action to be truly effective, we think it needs to include direct lending by either the ECB itself or some supra-national agency (e.g. the European Investment Bank), bypassing the dysfunctional banks," Norman Villamin, Europe chief investment officer at Coutts said last week.

The hopes of an ECB rate cut have buoyed markets over the past week. The STOXX 600 index has risen 5.2 percent over the past two weeks, while bond yields have fallen across the euro zone, with Italian 10-year yields falling to 3.88 percent and Spanish bond yields falling to 4.11 percent.

(Read More: ECB Rate Cut Could Bring 'Disappointment')

"When it comes to financial conditions, it's just the sovereign that's benefiting from the more favorable perceptions of Spain. Borrowing costs for businesses and households remain punitive and show how the transmission mechanism is still impairing the European Central Bank's monetary policy," Nicholas Spiro, managing director of Spiro Sovereign Strategy said on Tuesday.

-- By CNBC's Deep Bagchee; Follow him on twitter: @DeepBagchee

Contact Europe: Economy

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