FRANKFURT (MNI) – Friday’s unexpected jump in September Eurozone
consumer inflation has probably ended any expectation that the European
Central Bank will cut interest rates at its October 6 meeting. However,
the central bank might still loosen its policy by the end of the year.

While Friday’s HICP flash reading of 3.0% will not make
particularly edifying reading for the ECB, it is not expected to alter
the bank’s current view on risks to price stability, which it considers
now to be “broadly balanced” rather than “on the upside” — confirming
that its earlier policy tightening bias is gone.

Despite this, the ECB has said repeatedly that it expects inflation
to stay above 2% through most of this year. However, it sees HICP
dropping back down next year comfortably below its inflation threshold.

The ECB staff’s most recent forecasts yielded a midpoint HICP
forecast of 1.7% in 2012. That forecast is in line with those of other
international institutions.

Expectations of a cut in the bank’s key refinancing rate were
already diminished following comments from Governing Council member Yves
Mersch, who told Market News International earlier this week that
speculation of a big 50 basis point rate cut amounted to “wild
expectations” by people who were not in touch with the central bank’s
inflation mandate.

Today’s Eurozone unemployment data for August, which showed a small
drop in the number of jobless people, offers another rationale for the
ECB not to cut its key policy rate precipitously.

With a rate cut effectively now off the cards for October and
possibly November, the ECB still possesses a number of tools in its
policy kit to address the slowing economy and turbulence in financial
markets created by the Eurozone debt crisis.

With short term money market rates still reflecting ongoing stress
within the key interbank lending markets, one option for the ECB could
be to cut its overnight deposit rate. That would discourage banks from
parking their cash at the central bank’s deposit window, thus addressing
one of the sources of tension in money markets.

Focusing on the deposit rate floor might have the support of the
hawks on the Governing Council, who are against any cut in the refi

While a deposit rate cut might prove a quick fix for the ECB, it is
unlikely to jump start interbank lending again given the level of
mistrust that characterizes the markets at present.

Borrowing from the ECB’s weekly liquidity operations remains close
to post-Lehman levels, continuing to highlight the stresses bearing down
on money markets.

There have been several hints this week and last that the ECB will
do what is necessary and possibly more to ensure banks avoid unnecessary
credit restraints. And some Council members had already suggested,
before today’s upside HICP surprise, that a refi rate cut was decidedly
less likely than new, and possibly longer-term, refinancing operations.

Malta’s central bank governor Josef Bonnici recently told MNI:
“More than interest rates, the provision of liquidity and funds to the
banking sector is probably of more significance [than the level of the
policy rate] at this stage.”

Nonstandard measures remain the likely tool the ECB will continue
to draw upon despite calls from some quarters to limit their use.

Given recent comments by officials, it seems likely the bank will
increase its support for commercial banks by offering unlimited
fixed-rate funding at maturities of up to one year.

The fact that the severe risk aversion that characterized much of
the early part of September has given way to a more stable market
environment, at least for now, will be another factor dissuading the ECB
from wielding the sledge hammer of rate policy.

Another thing to ponder is that October’s meeting will be the last
one for retiring ECB President Jean-Claude Trichet before he passes the
baton to Italy’s Mario Draghi.

One scenario gaining popularity is that Trichet could signal a rate
cut at his last press conference and then leave it to Draghi to push the
button. What Trichet almost certainly will not signal is that the ECB is
willing to finance any leveraging of the EFSF.

–Frankfurt Bureau: +49 69 720 142 email:–

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