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ECB governors huddle under dark clouds of deflation

LUXEMBOURG, Jul 2 – European Central Bank policymakers met on Thursday in Luxembourg as deflation clouds rolled over the recession-hit 16-nation eurozone.

The ECB governing council was expected to hold the bloc\’s main interest rate steady at an all-time low level of 1.0 percent until the effects of unprecedented action to boost lending take hold.

"Economic and monetary conditions currently prevailing in the eurozone suggest a status quo on rates," Natixis economist Cedric Thellier said amid signs of a possible pickup in activity late this year and after record ECB loans last week.

In Sweden, which is not a eurozone member, the central bank said on Thursday it would cut its key interest rate to a new record low point of 0.25 percent to boost that country\’s economy.

ECB president Jean-Claude Trichet was sure to face questions on deflation at a press conference following the rate decision here later in the day.

Eurozone consumer prices fell in June for the first time since the European Monetary Union was formed, with a provisional inflation figure of minus 0.1 percent that was far below the central bank target of just under 2.0 percent.

But "we expect Trichet to be utterly un-committing," Goldman Sachs economist Erik Nielsen forecast.

And "if asked about last week\’s one-year repo, he\’ll say that they are satisfied," Nielsen added in reference to a groundbreaking ECB loan operation.

With the economy floundering in recession, the ECB has launched an enormous life raft, lending banks 442 billion euros (626 billion dollars) for a year at 1.0 percent, the most it has ever provided at one time.

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It was the central bank\’s first 12-month refinancing operation, and drew an all-time high of more than 1,100 commercial banks.

The ECB must now deal with deflation.

A broad-based decline in prices can incite households and businesses to postpone spending, supressing activity and threatening jobs which are already being lost rapidly in countries like Ireland and Spain.

Rising unemployment could reinforce deflation by putting pressure on wages that contribute to core inflation, as opposed to volatile oil prices that are the main, but temporary reason for the current decline.

"The risk that consumer prices will fall for longer than currently expected is very real in our view," economists at Capital Economics warned.

Slumping producer prices and a glut of industrial output capacity because of the recession were other potential aggravating factors.

In response, the ECB also plans to buy 60 billion euros worth of low-risk corporate bonds to prime business finance markets and has urged banks to lend more rather than hoard the windfall loans to dress up their books.

"The hope is that the ECB liquidity boost will translate into additional lending to the broader economy, though there is no guarantee that this will happen," noted Daniele Antonucci at Capital Economics.

Recent ECB data show annual growth of bank lending to the private sector slowing in May to a record low of 1.8 percent, though that figure did not reflect results from the central bank\’s record loans.

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Commercial banks are trying to limit risks faced by lending to companies and households after getting stung during the US subprime crisis and failure of the investment bank Lehman Brothers.

German central bank governor Axel Weber, a prominant ECB council member, has warned that if lending did not pick up, the ECB could bypass banks and extend credit directly by buying other kinds of corporate debt.

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