Central Banks

Pressure grows on ECB to cut interest rate

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A growing number of economists expect a rate cut by the European Central Bank (ECB) on Thursday or in December, as data for the euro zone raises concerns about the strength of the euro zone's recovery.

Last week's surprisingly low inflation data sparked concerns that the 17-country euro zone is heading for a period of deflation and boosted expectations of a near-team rate cut by the central bank when its governing council meet Thursday.

Euro zone HICP (Harmonised Index of Consumer Prices) inflation fell to a near-four-year low of 0.7 percent in October, year-on-year. This marks a fall from 1.1 percent in September – and is significantly below the ECB's target of just below 2 percent.

Japan suffered a "lost decade" of deflation, where companies cut their prices to revive lackluster demand, which in turn hits the businesses' revenue and has a knock-on effect on the economy. The euro zone has only just come out of a 18-month recession, with gross domestic product (GDP) growing 0.3 percent in the second quarter. The ECB's President, Mario Draghi, would be keen to avoid any factor that could put the brakes on that nascent recovery.

The inflation data were followed by business surveys, published Wednesday, which revealed that although euro zone business activity continued to grow in October, the pace of the expansion had slowed.

While on Tuesday, the European Union's Commission warned that euro zone unemployment would remain near its current record high - of 12.2 percent - for the next two years amid subdued economic expansion. It reduced its growth forecast for the region in 2014 to 1.1 percent.

Don't expect the ECB to cut rates: Rabobank
Don't expect the ECB to cut rates: Rabobank

Banks UBS, RBS and BofA Merrill Lynch said they expect the ECB to announce a quarter-point cut to the its refinancing rate, which is at a record low of 0.5 percent, at the central bank's meeting on November 7, although they said it will refrain from cutting the deposit rate.

(Read more: More liquidity coming from ECB to avoid 'cliff': Nowotny)

"We believe that the October HICP print of 0.7 percent, the rather broad-based nature of disinflation, and the firm euro will force the ECB to re-consider, and shift towards a rate cut," UBS economists wrote in a research note.

But they added: "If the ECB were to cut rates, as we expect, it would still leave the bank in an uncomfortable position. After all, the ECB would then have essentially depleted its orthodox toolkit."

As well as addressing the problem of deflation, a rate cut would help weaken the euro -- the currency has risen by over 2.3 percent against the dollar this year – thereby making euro zone exports cheaper. BofA Merrill Lynch's global research team said a rate cut would "foster the ECB's credibility."

(Read more: Were the euro bulls just too hasty?)

"Indeed, the ECB has been reluctant to address the deteriorating inflation outlook for a while," the team wrote in a report. "By cutting the refi (refinancing rate), the ECB will underline that it is vigilant."

Not everyone is expecting this dramatic move on Thursday, however, although a number of banks – including Societe Generale and BNP Paribas - said the inflation data boost the chances of a rate cut in December.

"In our opinion, it is too soon for such a move to happen at the next press conference, but it is most likely in December when the ECB's staff releases its next macroeconomic forecast," SocGen economists Michel Martinez and Michala Marcussen wrote in a research note.

Some ECB Governing Council members have already indicated that falling inflation could trigger the central bank to act. In September, for instance, member Luc Coene was quoted as telling news agency MNI that if a drop in inflation would be "sufficient reason" to consider strengthening the ECB's accommodative stance.

Other council members, however, appear less concerned about inflation, with Ewald Nowotny saying earlier this week that a rate cut was unlikely.

Independent research firm Capital Economics said it believed that a rate cut remained off the table - despite "growing pressure" on the ECB to take further policy action.

(Read more: Euro zone not yet fixed: JPMorgan's Dimon)

"With the economic recovery still pretty fragile, the euro climbing higher and inflation falling sharply, President Mario Draghi may adopt a slightly softer stance at the ECB's interest rate press conference on November 7. But there appears to be little chance of bolder action in the form of an interest rate cut or more explicit forward guidance," Ben May, Capital Economics' European economist, wrote in a report on Thursday.

Liquidity concerns

Instead, he noted that the ECB could announce policy measures aimed at improving liquidity conditions across the banking industry. These could come in the form of more long-term refinancing operations (LTROs), which see the central bank lend money at a very low interest rate to euro zone banks, in an effort to boost lending to businesses and consumers.

Worries about the level of liquidity were heightened on Friday, following an announcement by the ECB that European banks would repay over 10.6 billion euros ($14,48) of crisis loans early, thereby draining cash from the system.

(Read more: Why the euro area remains a good investment bet)

Barclays said it expects the ECB to deal with these tightening monetary conditions by announcing another round of LTRO in December.

"With prior euro strength and LTRO repayments tightening monetary conditions recently, and inflation now running dangerously low, the case for easing is pretty clear, in our view," Barclays analysts said in a note. "A December LTRO is the most likely policy response, but a refinancing rate cut is also possible."

However in an interview with CNBC, Nowotny said the central bank would provide more liquidity to avoid a "cliff" effect once the LTROs come to an end.

He refused to comment on what kind of new liquidity provision the bank could introduce – whether it come in the form of another LTRO or shorter-term six month repurchase agreement (repo) arrangement.

Europe's banks have been at the heart of the euro zone's financial crisis, and the ECB has already offered two rounds of cheap, three-year loans.

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By CNBC's Katrina Bishop. Follow her on Twitter @KatrinaBishop and Google