By Marc Jones and Andrew Hay
FRANKFURT/MADRID (Reuters UK) - European Central Bank policymakers played down the threat of deflation on Tuesday and said it was important not to overreact to the financial crisis and cut interest rates too far, too fast.
ECB Executive Board member Lorenzo Bini Smaghi called the risk of deflation "remote," while Greek central bank chief George Provopoulos said the rate cuts and government stimulus together should help prevent a spiral of falling prices.
"While a number of factors suggest that inflationary pressures will decline significantly, there are currently no signs of deflationary expectations," Bini Smaghi said in a speech in Venice.
"As long as inflation expectations remain firmly anchored, deflation will therefore remain a rather remote risk."
Speaking later in Madrid, Bini Smaghi said rapid and large interest rate cuts could fail to cut borrowing rates for households and firms.
He cited the case of the United States where policy rates are lower than 1 percent but rates for mortgages and companies are in most cases higher than in the euro zone, where the European Central Bank has a policy rate of 3.25 percent.
"There is a risk that the policy action, even when rapid and ample, does not succeed in reversing the trend," Bini Smaghi said. "There is a risk policymakers run out of ammunition too early and remain without a means to escape."
Two quick-fire 50 basis point cuts since October have cut benchmark euro zone interest rates to 3.25 percent and analysts think they could go to 2 percent or lower next year if the region's current recession evolves into a major long-term slump.
Inflation eased to 3.2 percent from a peak of 4 percent in June and July and is expected to keep falling as growth and oil prices ease, leaving room for the ECB to cut rates further.
Bini Smaghi's warnings against overly drastic rate cuts were echoed by Austria's Ewald Nowotny.
"It makes sense to be rather cautious and keep some of the firepower, and that means of course that you cannot use it up all in one go," Nowotny said in an interview with news agency Bloomberg, bolstering analysts' expectations for another half-point cut on December 4.
Bini Smaghi said big cuts to rates carried a psychological risk and could leave the ECB powerless in future if the current economic problems dragged on.
"The exhaustion of all ammunition earlier in the process, when there is no evidence of a deflationary shock, reduces the margin of manoeuvre in case other adverse shocks occur," he said.
"It may contribute to, rather than obviate, a worsening of market sentiment, if it is interpreted as a signal that the central bank has a more pessimistic assessment of the economy than market participants."
Luxembourg's Yves Mersch has also said a large rate cut could be counterproductive.
ECONOMIC DOLDRUMS
Bloomberg reported that Nowotny did not rule out rates dropping to 2 percent -- which economists see by the second quarter next year -- although he was not quoted directly as saying so. But he played down the prospect of bumper cuts.
"The way the ECB has acted so far, I believe that we'll continue in this manner," he said.
Bini Smaghi said the financial crisis could dull the benefits of cuts if banks used them to improve profit and loss accounts rather than provide cheaper credit to businesses and consumer borrowers.
"If the transmission channel of monetary policy does not function, interest rate cuts have little impact on the real economy," Bini Smaghi said in Madrid.
He said central banks and governments had to focus more energy on restoring financial market confidence.
"Policy action must give priority to making markets function again," Bini Smaghi said. "Given the current market stress, the capital injection of the banking system must be abundant and generalised."
The euro zone is now officially in recession and the recent intensification of the financial crisis has scythed expectations for both economic activity and inflation.
The Organisation for Economic Cooperation and Development said on Tuesday it expects the region's economy to contract 0.6 percent in 2009, and the International Monetary Fund sees a shrinkage of 0.5 percent.
Analysts also expect the central bank staff to slash their growth and inflation forecasts when they are released on December 4.
Nowotny said that he hoped that the economy would begin to recover in the second half of next year.
"I would think that there is a chance that this slowdown could end by the middle of next year, because a number of countermeasures have been taken with regard to the banking sector, with regard to the real economy," he said.
Marko Kranjec, who heads the Slovenian central bank, said there was still no end in sight to the money market confidence problems that have effectively wiped out bank to bank lending.
"The liquidity situation is particularly difficult," Kranjec told a central bank function.
"What is worrying that there are no signs that it is cooling down... There is nobody who knows when this will stop."
(Writing by Marc Jones; Additional reporting by Krista Hughes) in Frankfurt)
