ECB keeps interest rates unchanged

The European Central Bank has voted to keep interest rates unchanged at 1.5 per cent, halting an interest rate rise cycle just five months after it started as the euro zone debt crisis weighs on the economy.

ECB president Jean-Claude Trichet said inflation risks in the euro zone are broadly balanced and flagged slow growth ahead for the currency area.

"We expect the euro area economy to grow moderately, subject to particularly high uncertainty and intensified downside risks," Mr Trichet told a news conference.

"Looking ahead, a number of developments seem to be dampening the underlying momentum in the euro area," said ECB president Jean-Claude Trichet.

Inflation should fall below 2 per cent in 2012, Mr Trichet said, and price risks were "broadly balanced".

That assessment marked a change from last month, when he said there were "upside risks to price stability". The change in the ECB's inflation view suggests it has abandoned its policy tightening course and that interest rates are now on hold.

The euro tumbled in response to the gloomy economic prognosis. A month ago, the ECB chief had said risks to the growth outlook were balanced.

ECB staff cut their growth forecasts to a range of 1.4-1.8 per cent this year from the 1.5-2.3 per cent seen in June. Next year, growth is expected to be between 0.4 and 2.2 per cent, down from 0.6 to 2.8 per cent previously.

Inflation is now predicted to fall back to between 1.2 and 2.2 per cent next year, for a midpoint of 1.7 per cent, which would be below the central bank's target of close to but below 2 per cent.

"A very thorough analysis of all incoming data and developments over the period ahead is warranted," Mr Trichet said. "We will continue to monitor very closely all developments."

A month after the ECB reactivated its controversial bond-buying programme, markets were also looking for signs of how the central bank plans to deploy the measure, which it is using to hold down government borrowing costs in Italy and Spain.

The ECB is concerned that by buying the sovereign bonds of Italy - the euro zone's third largest economy - it is only encouraging the Italian government to slacken efforts to shore up its finances, doing little to tackle to roots of the crisis.

By allowing market borrowing costs to rise, the ECB can raise pressure on Italy to implement austerity measures.

Italy responded to a renewed attack on its bonds by promising on Tuesday to hike value-added tax. The pledge came after Italian bond yields crept up to around 5.5 per cent, above the 5 per cent level the ECB had appeared to be targeting.

Mario Draghi, who will succeed Mr Trichet from November 1st, warned euro zone governments earlier this week they should not assume the bond purchases would continue indefinitely.

"I think the ECB's view is that the programme is temporary, but it makes no sense to be shouting about it, it makes sense to be a bit opaque and just say the programme is ongoing," said Nick Kounis, an economist at ABN Amro.

Policymakers' failure to resolve the debt crisis has eroded confidence in the 17-country euro zone, slowing the economy. The euro zone's dominant service sector was effectively stagnant last month after two years of growth and manufacturing activity, which drove a large part of the economic recovery in the region, shrank for the first time since September 2009.

Some private sector economists put the chance of a return to recession at least 50 per cent.

Reuters