Euro Rates Stay 1%, Trichet Downplays Deflation Risks

The European Central Bank left its main refinancing interest rate unchanged at a record low of 1.0 percent, as expected. The program to buy covered bonds will go ahead as planned, president Jean-Claude Trichet said.

The decision had been seen as a near certainty. Eighty-one of 82 economists polled by Reuters before the meeting, held this month in Luxembourg, had predicted no change from the bank.

"This was entirely expected," said UBS economist Sunil Kapadia. "We are not expecting any more additional non-standard measures. With the data in the market improving there is no compelling reason to do more right now."

The euro hit session lows after ECB President Jean-Claude Trichet started talking about the risks facing the euro zone.

"Economic activity over the remainder of this year is expected to remain weak, but should decline less strongly than was the case in the first quarter of 2009," Trichet said. "Looking ahead into next year, after a phase of stabilization, a gradual recovery with positive quarterly growth rates is expected by mid 2010."

Euro zone consumer prices fell 0.1 percent year-on-year in June, the first time the harmonized index has dropped since the euro's launch in 1999.

"We expect the current episode of extremely low or negative inflation rates to be shortlived and price stability to be maintained over the medium term," he said.

Earlier Sweden's central bank shocked markets by cutting its interest rates by a further 25 basis points to 0.25 percent.

But the ECB is likely to refrain from any new policy steps so that it can take stock of its unconventional measures to tackle the euro zone recession — last week's injection of almost half a trillion euros of ultra-cheap funding into money markets, and the soon-to-be-launched program to buy 60 billion euros' worth of mortgage and public debt-backed bonds.

"The current (interest) rates remain appropriate taking into account all the information and analysis that has become available since our meeting on June 4, 2009," Trichet said.

Markets have hoped Trichet will fill in some of the missing details of its unorthodox plan to buy bonds, a policy designed to ease longer-term interest rates.

The program will start on July 6 and will be implemented gradually, depending on market needs, the ECB said Thursday afternoon.

The program intends to contribute to a further decline in money market rates, ease funding conditions, improve liquidity and encourage banks to lend to their clients, the ECB said in a statement.

The ECB will buy around 8 percent of the total covered bonds, according to Trichet.

Macro Under Microscope

Data earlier showed unemployment hit a 10-year peak in the euro zone in May. U.S. jobless figures released earlier showed 467,000 jobs were lost in June, more than expected.

Despite the rising euro zone unemployment, tightening credit conditions and the risk of deflation, the latest economic data suggest the worst of the economic tempest may now have passed.

However, other signals point to a puny recovery at best.

The supply of credit to firms and consumers has continued to tighten, euro zone prices fell in June for the first time since the introduction of the euro and GDP slumped 4.8 percent year-on-year in the first three months of the year.

Despite successfully pumping 442 billion euros into euro money markets last week the signs are not yet encouraging.

Data on Wednesday showed that institutions are hoarding large amounts of cash at present, rather that lending it out as hoped.

Deutsche Bank economist Mark Wall noted comments on the problem by two ECB policymakers, Executive Board member Jose Manuel Gonzalez-Paramo and Bundesbank President Axel Weber.

"Gonzalez-Paramo raised it and Axel Weber was clearly threatening last week when he said if banks don't pass on this cheaper funding then they will have to be bypassed," said Wall.

"So the question is: at what point does the ECB conclude that the banking sector is dysfunctional? And at what point do they decide that they need to switch strategy?"

— CNBC.com contributed to this story

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