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ECB Holds Fire As Deflationary Risks Persist

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The European Central Bank left interest rates unchanged at a record low at the start of the year, as it battles deflationary tendencies, while a gradual recovery has become more evident in the 18-nation economy.

In the the first rate-setting session after Latvia joined the Eurozone on January 1, a stronger euro is apparently the imminent threat faced by the ECB. A stronger currency adds to the deflationary worries and risks hurting the fragile recovery.

The Governing Council kept the main refinancing rate unchanged at 0.25 percent on Thursday, for a second straight month, following their meeting in Frankfurt. The decision was in line with economists' expectations.

The marginal lending facility rate was held at 0.75 percent. The deposit facility rate was kept at zero, where it has remained since July 2012.

In November, the bank had unexpectedly cut the refi rate by a quarter-point, which was the first reduction since May. The marginal lending rate was also reduced by 25 basis points then.

ECB President Mario Draghi is set to hold the post-meeting press conference at 8.30 am ET, when he is expected to drop hints regarding the future course of action against deflationary risks.

"While Draghi will no doubt pay lip service again to his policy artillery, he may choose to keep the powder dry for now," Capital Economics Chief European Economist Jonathan Loynes said. "But the pressure for the ECB to act again seems likely to build quickly."

The central bank was widely expected to maintain status quo this month after Draghi told the German weekly Der Spiegel last week that there was no need for immediate action. He also suggested that low inflation remained policymakers' biggest worry.

"The determination to fight any deflationary tendencies has never been higher than currently," ING Bank Senior Economist Carsten Brzeski said.

"As a strong exchange rate looks as the most imminent threat, we still think that a negative deposit rate would be the ECB's first line of defense if and when deflationary risks increase further."

Recent data indicate the sluggish pace of economic recovery amid deflationary risks and high unemployment. Further, credit growth and liquidity conditions remain weak.

Economic growth moderated in the third quarter to 0.1 percent from 0.3 percent in the three months to June, when the euro area economy exited its longest ever recession.

The recovery likely gained some traction in the fourth quarter of the year, economists say, citing recent data.

Inflation slowed unexpectedly in December to 0.8 percent from 0.9 percent in the previous month. The figure has held below the ECB's target of 'below, but close to 2 percent' for eleven months.

Figures released yesterday showed that retail sales grew stronger-than-expected in November, suggesting that consumer spending may have contributed positively to GDP in the fourth quarter.

However, unemployment remains unacceptably high. The figure has held steady at 12.1 percent for eight consecutive months.

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