FRANKFURT—The European Central Bank opened the door to interest-rate cuts if needed to bolster a weakening economic recovery—a dramatic U-turn from its decision to raise interest rates just two months ago.
European Central Bank did not raise rates but President Jean-Claude Trichet warned that the euro zone's economy will grow more slowly than previously expected and that inflation will remain high, and growth will fall. Paul Vigna discusses the ECB forecast with WSJ's Shira Ovide and Vincent Cignarella.
Economic risks have "intensified" to the downside with "enormous" uncertainty, ECB President Jean-Claude Trichet told reporters after the central bank held its main policy rate at 1.5%. He called the ECB's reassessment of the economic outlook "significant," and highlighted weakening global growth, declines in equity markets and strains in euro-zone government bond markets as trouble spots.
At the same time, Mr. Trichet defended the ECB's two rate hikes earlier this year, saying they were needed to keep inflation in check. He also launched an uncharacteristically passionate defense of the ECB's recent decision to buy Italian and Spanish bonds, saying the moves were needed to restore smooth transmission of the ECB's interest-rate decisions to financial markets and the economy.
"We stand ready to do whatever is necessary," Mr. Trichet said, adding that the ECB will "monitor very closely all developments."
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Until Thursday, the ECB had only said that it would closely monitor what it saw as upside risks to inflation. Those risks are now balanced, Mr. Trichet said. At 2.5%, annual inflation is still above the ECB's 2% target. But ECB staffeconomists expect it to fall to 1.7% in 2012, according to revised projections released Thursday.
"This is an ECB that's worried" about the economy, said Nick Matthews, economist at Royal Bank of Scotland. "It's clear that the ECB has an easing bias and may be cutting rates by the end of the year," Mr. Matthews said.
The euro zone expanded just 0.7%, at an annualized rate, in the second quarter as the region's two largest economies, Germany and France posted little or no growth. A collapse in business and consumer sentiment last month raised a grimmer prospect: The euro zone may be headed toward another recession.
The risks of renewed contraction in the world's advanced economies "has gone up," the Organization for Economic Cooperation and Development said Thursday. The Paris-based organization of developed and large developing economies urged central banks with the "scope" to do so to consider easing rates.
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ECB President Jean-Claude Trichet
But recent data suggest some of the gloom may be overblown in Europe. German industrial production jumped 4% in July from June, though business sentiment slid that month. Consumer spending in the euro zone rose in July. The economy is softening but isn't falling back into recession yet, analysts say.
Euro-zone gross domestic product "is expected to increase very moderately in the second half of this year," Mr. Trichet said. ECB staff cut their 2012 growth forecast to 1.3% from 1.7%. If the economy stabilizes even at weak growth rates, thenthe ECB will likely keep interest rates steady, some economists said.
"It may take contraction for them to actually cut rates," said Howard Archer, economist at consultancy IHS Global Insight.
The ECB raised rates in April and again in July even as other major developed-country central banks such as the Federal Reserve, the Bank of England and the Bank of Japan held rates at crisis-era lows closer to zero. The Bank of England voted Thursday to keep rates at a record-low 0.5%, but didn't announce any plans to resume its asset-purchase program, known as quantitative easing.
The ECB's sudden shift opens it to renewed criticism that—as in July 2008 when it increased rates just weeks before the collapse of Lehman Brothers—officials didn't recognize early warning signs on the economy and overestimated inflation risks, exacerbating the slowdown.
The ECB made the right call, Mr. Trichet said Thursday. "We think what we did was appropriate," he said, referring to this year's rate hikes. "We preserved a solid anchoring of inflation expectations."
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Mr. Trichet vigorously defended the ECB's decision, made one month ago, to reactivate its government bond purchase program and expand it to include Italian and Spanish bonds. The ECB has bought more than €50 billion in government bonds since restarting the program, which had been dormant for four months.
That provoked a backlash in Germany, where government bond purchases by central banks are seen as an inflationary taboo that puts central bankers in the realm of fiscal policy. The head of Germany's central bank, Jens Weidmann, voted against reactivating the purchases. German President Christian Wulff, whose position is largely ceremonial, has called the ECB's bond purchases "politically and legally questionable." The head of German's center-left SPD party, Sigmar Gabriel, has also blasted the move.
His voice rising uncharacteristically, Mr. Trichet said the ECB has displayed an "impeccable, impeccable" adherence to price stability during its 12-year history. "I would very much like to hear the congratulations for an institution that has delivered price stability in Germany...which is better than has ever been achieved in this country," he said, responding to a question about Mr. Gabriel's criticism.
Mr. Trichet repeated his insistence that euro-zone parliaments approve changes to Europe's €440 billion rescue fund that would allow it to purchase bonds in financial markets, alleviating the ECB of that task.
The ECB president dismissed concerns that the euro zone suffers from a lack of liquidity in its banking system, and rejected claims that the region's banks are in urgent need of more capital. International Monetary Fund managing director Christine Lagarde caused a stir last month when she said European banks needed urgent recapitalization.
"I will not dramatize the situation as has been done by some," Mr. Trichet said, without referring specifically to Ms. Lagarde's comments.
Write to Brian Blackstone at brian.blackstone@dowjones.com
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