In Surprise Move, ECB Cuts Interest Rates

The surprise move sent stocks soaring and the euro's value tumbling.

Mario Draghi, President of the European Central Bank, addresses the press following the meeting of the Governing Council in Frankfurt, Germany, on Nov. 7, 2013.
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The European Central Bank cut interest rates to a new record low Thursday, from 0.5 percent to 0.25 percent. The move surprised global markets, sending the euro falling against the dollar and pushing European stock indexes higher.

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The rate cut is seen as a move to counteract low inflation in the euro area. In October, Eurozone inflation fell to 0.7 percent from 1.1 percent in September, well below the 2.0 percent that ECB President Mario Draghi said in a Thursday press conference was the bank's target.

"We may experience a prolonged period of low inflation to be followed by gradual upward movements toward an inflation rate of below but close to 2 percent later on," Draghi told reporters, as reported by Reuters.

While persistently high inflation can rob consumers of buying power, low inflation can restrain economic growth. Growth and inflation feed off each other cyclically, so low inflation expectations can cut economic growth.

Interest rates are one of the key economic controls at a central bank's disposal. Lowering the interest rate can boost a flagging economy by encouraging borrowing and also help counteract deflation.

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While the rate cut will have economic consequences, one economist says it is also the central bank way of sending a signal that it is ready and willing to act. This is a distinction from past ECB regimes, says one economist.

"It is obvious that the ECB under President Draghi has become more pro-active than under any of his predecessors," said Carsten Brzeski, an economist at ING Bank, in a note, as reported by USA Today.

"I think it's more a sign of the ECB showing they've been too passive and they need to be more aggressive," says Gus Faucher, senior economist at PNC Financial Services.

Since July, the central bank's forward guidance had stated that its Governing Council expected interest rates to remain steady or lower "for an extended period of time." Had the ECB not lowered interest rates in response to inflation, says another expert, it would have undermined the bank's legitimacy.

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"If the ECB had not reacted to euro-zone consumer price inflation dropping to just 0.7% in October by cutting interest rates, it could have led the markets to questioning how meaningful the ECB's forward guidance was," wrote Howard Archer, chief European and UK economist at IHS Global Insight, in a commentary.

Draghi also made it clear the central bank will take further action as it deems necessary.

"We have a whole range of instruments to activate before reaching the lower bound ... in principle we could even cut further the interest rate," Draghi told reporters.