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ECB, abandoning tradition, commits to record low rates

A structure showing the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt July 11, 2012. REUT
A structure showing the Euro currency sign is seen in front of the European Central Bank (ECB) headquarters in Frankfurt July 11, 2012. REUT

By Paul Carrel and Sakari Suoninen

FRANKFURT (Reuters) - The European Central Bank broke with precedent by declaring it would keep interest rates at record lows for an extended period and may yet cut further, responding to turbulence caused by the U.S. Federal Reserve's exit plan from money-printing.

Less than two hours after the Bank of England gave a steer about future interest rate moves, ECB President Mario Draghi followed suit, abandoning the euro zone central bank's customary insistence that it never precommits on policy.

Draghi said the decision to issue 'forward guidance' was driven by market volatility, which took hold after the Fed last month set out a plan to begin slowing its stimulus.

"The Governing Council expects the key ECB rates to remain at present or lower levels for an extended period of time," Draghi told a news conference after the ECB left interest rates at 0.5 percent, calling it a "very significant step".

"50 basis points is not the lower bound," he said.

Draghi did not say exactly how long ECB rates would stay at record lows. "It's not six months, it's not 12 months. It's an extended period of time."

The council had discussed cutting rates but decided against, he said, and the bank could also consider cutting the deposit rate on bank deposits at the ECB - already at zero - in an attempt to foster more lending.

Whether forward guidance about policy can mitigate the impact of the Fed's move on other countries remains to be seen.

"President Draghi's guidance will protect the front end of the euro curve, say out to 2-3 year maturities, against rising rates in the U.S.," said Andrew Bosomworth, senior portfolio manager at Pimco, the world's largest bond fund.

"But for maturities beyond the 'extended period of time' horizon, they will move in sync with Fed-induced swings in global rates."

German Bund futures hit a day's high in response to the ECB's gambit and the euro fell, hitting a five-week low, down 0.7 percent on the day.

Earlier, at former Canadian central bank chief Mark Carney's debut policy meeting as governor, the Bank of England said market pricing for future interest rate rises was "not warranted by the recent developments in the domestic economy".

Draghi said it was a coincidence that the two central banks had gone down a similar path, adding: "We (the ECB) discussed several forms of forward guidance ... The Governing Council was unanimous on this formulation."

LIMITED OPTIONS

The move also highlights the paucity of policy options open to the ECB at a time of renewed turmoil in the euro zone.

The ECB met against a backdrop of political crisis in Portugal that pushed its benchmark bond yields above 8 percent on Wednesday, a spike that stirred angst in financial markets already jittery after the Fed's intervention.

The tensions there, and in Greece, risk sapping confidence a year after Draghi imposed some calm by vowing to do "whatever it takes" to save the currency.

Instability in Italy's ruling coalition and Greece's scramble to convince its lenders to dole out another tranche of aid have added to the sense of turmoil.

But with the ECB's bond-buying program requiring a country to seek outside help from the euro rescue fund first and be issuing debt regularly on the bond market, none of the euro zone members in trouble qualify for that help, begging the question what can the ECB do.

Draghi said the ECB rules governing bond-buying intervention were unchanged, signaling Portugal would get no help to resolve a crisis that has seen its bond yields rocket this week.

Concluding its review of the Italian economy, the International Monetary Fund urged more dramatic action from the ECB to help the euro zone, in the form of direct assets purchases and more long term cheap loans "of considerable tenor" to banks.

Draghi stuck with the bank's forecast that the euro zone economy would improve in the second half of the year but said the risks to that were skewed to the downside.

"We have actually penciled in a rate cut in September by the ECB and that ties in with the possibility that the Fed could start tapering (its stimulus) around September," said Howard Archer, economist at IHS Global Insight. "I suspect they may well have to put their money where their mouth is."

(Writing by Mike Peacock)

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