UPDATE 5-ECB cuts rates to new low, sees protracted low inflation
* ECB cuts main rate to new record low of 0.25 percent
* Cut defies expectations, follows inflation slump
* Euro tumbles in response
* ECB also extends full liquidity operations 'til mid-2015
FRANKFURT, Nov 7 (Reuters) - The European Central Bank cut interest rates to a new record low on Thursday and said it would prime banks with liquidity into 2015 to prevent the euro zone's recovery from stalling as inflation tumbles.
The move took financial markets by surprise - the euro fell sharply in response while European shares rose.
The 23-man Governing Council had faced intense scrutiny after a shock slump in euro zone inflation to 0.7 percent in October, far below the ECB target of just under 2 percent.
"We may experience a prolonged period of low inflation to be followed by gradual upward movements towards an inflation rate of below but close to 2 percent later on," ECB President Mario Draghi told a news conference.
The ECB cut its main refinancing rate by 25 basis point to 0.25 percent. It held the deposit rate it pays on bank deposits at zero and cut its emergency borrowing rate to 0.75 percent from 1.00 percent.
"We have a whole range of instruments to activate before reaching the lower bound ... in principle we could even cut further the interest rate," Draghi said.
Calls from euro zone government ministers and industry for the ECB to loosen policy to help bring down the euro's exchange rate had also heaped pressure on the Council, though few analysts had expected a move this month.
Euro policymakers have played down the threat of Japan-style deflation, which led to a "lost decade" there, but appear to be taking no chances.
Draghi said there was general agreement on the need to act but there were differences over when to act.
"Deflationary risks and the stronger euro seem to have motivated the ECB's move. It is obvious that the ECB under president Draghi has become much more pro-active than under any of his predecessors," said ING economist Carsten Brzeski.
All but one of the 23 money market traders polled by Reuters this week expected the ECB to remain on hold at Thursday's meeting, pending a clearer view about where euro zone inflation is heading.
The euro EUR= slid more than 1 percent on the day to hit a seven-week low of $1.3304, down from around $1.3490 just before the ECB announcement.
LIQUIDITY FOR LONGER
Draghi reaffirmed the central bank's forward guidance that rates would hold at "present or lower levels" for an extended period and said he saw no threat of broad deflation.
He also said banks would be able to rely on as much liquidity as they needed for longer, with the bank's main refinancing operations to be offered at fixed rate with "full allotment" at least until July 2015.
European bank shares climbed.
Adding to the ECB's dilemma over how to support a fragile recovery has been a fall in excess liquidity - cash beyond what lenders need to cover day-to-day operations - as banks repay 3-year ECB loans, known as LTROs, early before a health check next year.
These early repayments are expected to push interbank lending rates higher over time and the ECB has been considering pumping more liquidity into the system to offset this development.
Draghi said there was no meaningful discussion on Thursday about the need for a new LTRO.
"Now that the policy rate is at the lower bound, it begs the question how the ECB will react next year if growth and inflation fail to materialise," said Andrew Bosomworth, senior portfolio manager at PIMCO in Munich.
"While quantitative easing would be the next logical step, I think the politics of asset purchases and the bifurcation within the euro zone mean the deflationary threshold for QE will be much higher than in other countries conducting this experiment."
Ireland, a euro zone success story which on Thursday got a green light to exit its bailout programme after years of austerity, welcomed the ECB's move.
"We wanted interest rates to go down and it helps our position going back into the markets because the spreads in Europe should narrow now," Finance Minister Michael Noonan said.
"The interest rate reduction and the suggestion that the currency level might go down a little would both help our exports and help our economy to grow."
Italian Prime Minister Enrico Letta also lauded the ECB.
"It shows the ECB cares about growth and competitiveness in Europe," Letta told a news conference in Dublin, adding that the rate cut would allow a "re-balancing" of the euro-dollar rate which had been "a source of difficulty in recent months".