ECB opted to cut interest rates by 25bps in a surprise decision

The ECB decided last week to cut the interest rate on its main refinancing operations by 25 basis points to 1.25% (effective 9 November 2011). The market was expecting the ECB to leave interest rate unchanged. Out of the 55 analysts surveyed by Bloomberg ahead of the decision, only 6 expected the ECB to cut rates.

The ECB had hiked interest rates by 25bps on 13 April 2011 and again on 13 July 2011, citing concerns about inflation. Inflation in the Euro-area has been above the target rate of 2% since December 2010, and is currently at 3% - the highest level in 3 years. However, the new President of the ECB, Mario Draghi, who took over from Jean-Claude Trichet at the end of October 2011, has clearly responded to the worsening economic conditions and the increased risk that the Euro-area lapses back into recession during 2012.

The mandate of the ECB is primarily to ensure price stability. Once price stability is achieved, the ECB can then focus on encouraging employment and economic growth. However, most analysts expect Euro-area inflation to moderate meaningfully next year, and agree that the most pressing concern is the rapidly weakening economic environment. On reflection, the ECB should simply not have hiked interest rates earlier this year. 

We expect the ECB to cut rates by a further 25bps in early 2012.

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