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The European Central Bank cut its benchmark interest rate by 25 bps to 1.25 percent, a new historical low. However, the EUR/USD rallied after the rate cut announcement since most investors were expecting a 50 bps rate cut. Later, the EUR/USD gave back some of its early gains after Jean-Claude Trichet, the ECB president, acknowledged that the decision to cut rates by only a quarter-point was not unanimous and some type of quantitative easing could be discussed at the next ECB meeting.

The ECB risks running out of options to boost liquidity

The Euro zone economy is gradually succumbing to tight credit conditions and a slowing global economy. Recent data on business sentiment, consumer spending and industrial production continues to point towards a sharp contraction in economic activity in the euro zone and lower interest rates combined with some sort of quantitative easing are certainly needed to prevent the region from falling into a long-term recession. However, as we approach a zero-interest-rate-policy (ZIRP), some investors are becoming increasingly concerned that the ECB will run out of options to boost liquidity and minimize the impact of this financial crisis. In fact, unlike the United States Federal Reserve, the ECB cannot simply implement quantitative easing by buying government bonds because the European Union does not have a common government bond.

The ECB Has Been Slower to Cut Rates than Other Central Banks. What does it mean for the euro?

I have been taking bearish positions against the euro since the EUR/USD exchange rate was trading at 1.60 and I expect more EUR/USD, EUR/JPY and EUR/GBP weakness going forward on speculation the ongoing financial crisis will force many European banks to announce more losses related to toxic mortgage assets. To some extent, Europe's economic growth has been a perfect lagging indicator for the rest of the world economy. Back in 2008, European policy leaders thought the financial crisis would be confined to the United States and the ECB was slower to act than the Federal Reserve. Inflation in the euro zone was well above a level consistent with price stability and the ECB was concerned with second-round effects of energy prices in wage and price setting. However, the credit storm that began in the U.S. end up affecting the euro zone and European banks were forced to write off $229 billion out of a global total of $588 billion in losses related the collapse of the U.S. subprime market. While no one can deny that Jean-Claude Trichet, the ECB president, has done a lot to boost the euro as a credible alternative for the U.S. dollar, it is also becoming clear that the ECB perhaps underestimated the size of the financial crisis by keeping interest rates too high for too long. In fact, the euro zone is now in a technical recession and facing the most serious test since the euro was introduced to the world financial markets in 1999.

Central Bank Interest Rates Across the World

Interest-rates-map

source: tradingeconomics.com

Antonio Sousa is a Chief Strategist for DailyFX.com at FXCM in New York City where he performs global economics research and develops systematic trading strategies. To contact him please e-mail asousa@fxcm.com.