European Central Bank (ECB) Vice President Lucas Papademos said last night that more interest rate cuts may be needed to shield the euro zone economy and stressed that deflation would be kept at bay.
"We will do what is necessary, in terms of the timing and in terms of the size (of interest rate policy action) to ensure that price stability is preserved," he said.
Mr Papademos spoke to reporters on the sidelines of the annual meeting of the American Economics Association, following a panel discussion on the 10th anniversary of the euro common currency, which is now shared by 16 European nations.
"Inflation will not be allowed to fall significantly below 2 per cent for a protracted period of time, over the medium term, which we do not expect on the basis of our present analysis," he said.
The ECB has already reduced its benchmark interest rates by 1.75 percentage points in the past two months to 2.5 percent and is expected by markets to cut by at least another 50 basis points when it holds its next policy meeting, on January 15th.
Mr Papademos spelled out the perils of further cuts, but also made plain that these would not prevent the ECB from taking aggressive action if it is warranted.
"Cutting interest rates to very low levels must be judged with special care because of the long-term implications for price stability.
"Having said that, the level of policy rates will be decided so as to ensure over the medium term that inflation will be in line" with the ECB's price stability goal of below, but close to 2 per cent, he said.
Mr Papademos told the panel that inflation would weaken sharply in the coming months, but stressed that he did not believe that the region would slip into deflation.
"In the euro area, although inflation could drop considerably around the middle of this year - the exact amount depending on future oil price developments - it is currently projected that price developments over the medium term imply that the risk of deflation, that is, a protracted decline in the price level that would be embedded in inflation expectations, this risk is nil," he said.
"This assessment is confirmed by market-based inflation expectations implicit in inflation swaps," Mr Papademos added.
He also noted that these market instruments predicted substantially higher risks that the United States would suffer from deflation, or a protracted general decline in prices. This was particularly damaging in Japan in the 1990s and contributed to its so-called lost decade of economic stagnation.
Mr Papademos said that recent economic data, while gloomy, had not been much worse than expected and did not demand the ECB cut growth forecasts; which currently look optimistic compared to the assessment of private sector analysts.
Reuters