ECB set for second straight rate cut as euro zone economy ails

First back-to-back rate cut in 13 years
Recent economic data supports ECB rate cuts
High interest rates hurt investment, economic growth
Markets almost completely priced in three more rate cuts by March

FRANKFURT, Oct 17 (Reuters) – The European Central Bank may cut interest rates for the third time this year on Thursday, arguing that inflation in the euro zone is now increasingly under control and the economy is stagnating.

The first back-to-back rate cuts in 13 years would mark a shift in focus for the euro zone's central bank from reducing inflation to protecting economic growth, which has lagged behind the U.S. for two straight years.

Recent economic data likely tipped the balance in favor of a rate cut at the ECB, with business activity and sentiment surveys as well as September inflation readings all slightly lower than expected.

In the wake of the release, several ECB speakers, including President Christine Lagarde, flagged the possibility of fresh cuts in borrowing costs this month, prompting investors to fully price the move.

“We now expect the ECB to cut rates by 25 basis points at each of the next four meetings, given the loss in growth momentum and the moderation in inflation,” said UBS economist Reinhard Kluss.

A quarter-point cut on Thursday would lower the rate the ECB pays on bank deposits to 3.25%, and money markets would almost fully price in three more cuts through next March.

Lagarde and colleagues are unlikely to give a clear indication of future action on Thursday, repeating their mantra that decisions will be made “meeting by meeting” based on incoming data.

But most ECB watchers think the die is cast for cutting at every meeting until the spring.

“We expect the ECB to cut the deposit rate by 25 basis points at the October 17 meeting and continue to cut the deposit rate by 25 basis points at each meeting until March,” said Antonio Villaroa at Santander CIB.

“That level may still prove above neutral during that period, and so we expect the final 25 basis point cut to be announced in the second quarter, possibly in June,” Villarroya added.

A neutral interest rate is a theoretical level at which monetary policy neither cools nor stimulates the economy, and investors see a range of 2% to 2.25%.

Money market traders see the ECB's deposit rate falling to just 2% over the next year

Inflation and Growth

The ECB can finally claim that it has tamed the worst bout of inflation in a generation.

Prices rose just 1.8% last month, falling below the bank's 2% target for the first time in three years. While inflation may rise above 2% by the end of this year, it is expected to be close to that level or even slightly lower over the “medium term,” the time horizon that policymakers have looked at.

Yet the economy has to pay a heavy price for this.

High interest rates have dampened investment and economic growth, which has struggled for nearly two years. The latest data, including industrial output and bank lending, points to more of the same in the coming months.

An exceptionally resilient labor market is also now starting to show some cracks, with the vacancy rate – or the ratio of empty jobs as a share of the total – falling from record highs.

It fueled calls inside the ECBto ease policy before it was too late.

“Now we face a new risk: below target inflation, which could hamper economic growth,” Portuguese central banker Mario Centeno said recently. “Fewer jobs and reduced investment will add to the already bearish attrition ratio.”

Some of that weakness is due to structural problems, such as high energy costs and low competitiveness holding back Europe's industrial powerhouse, Germany.

These problems cannot be fixed by lower interest rates alone although they can help margins by making capital cheaper.

“We cannot move on to growth,” ECB board member Isabelle Schnabel said. “At the same time, fiscal policy cannot solve structural problems.”

Editing by Emelia Sithole-Mataris and Toby Chopra

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