The European Central Bank lowered its euro zone growth forecast after holding interest rates at record lows on Thursday, and said things would have been much worse without its dramatic action to pump a trillion euros into the banking system.
The ECB's staff forecasts showed the economy could shrink by 0.5 percent this year and at best grow by a meagre 0.3 percent, a slight downgrade of its previous estimate.
Available survey indicators confirm signs of a stabilisation in the euro area economy. However, the economic outlook is still subject to downside risks, ECB President Mario Draghi told a news conference, after the central bank left interest rates at 1.0 percent.
Meanwhile, a recent 20 percent rise in oil prices is rekindling inflation to some extent. It is now forecast to be higher, at between 2.1 and 2.7 percent this year, above the ECB's target of close to but below two percent.
Owing to rises in energy prices and indirect taxes, inflation rates are now likely to stay above 2 percent in 2012, with upside risks prevailing, Draghi said.
The latest Reuters poll of 74 economists suggests the ECB will hold rates at 1.0 percent until well into 2013.
German Bund futures rose while European shares and the euro trimmed gains after Draghi said growth forecasts had been cut.
In our view, the projections are still relatively optimistic as hard data have failed to show the stabilisation process, especially in the (euro zone) periphery. Risks are clearly skewed to the downside, said Annalisa Piazza at Newedge Strategy.
Draghi was in no doubt that the ECB's twin three-year funding operations, which pumped over 1 trillion euros into the euro zone banking system, had saved the currency bloc from a serious crisis.
Borrowing costs for debt strugglers such as Italy and Spain have tumbled as a result and Draghi said markets, including the interbank lending market, had reopened and real money investors were returning to euro assets.
All in all, we see that great progress has been achieved, he said. Simply compare what the situation was in November last year and what it is today.
Nonetheless, he put the onus back on governments to fight the euro zone crisis from now on, demanding further progress towards restoring sound fiscal positions and implementing the structural reform agenda.
The euro zone economy has stabilised over recent months, in part thanks to the ECB's back-to-back rate cuts in November and December and the twin funding operations, which brought calm to euro zone debt markets.
But that is likely to be the extent of the ECB's policy response to the euro zone crisis, not least because of growing signs of disquiet among some of his colleagues.
Bundesbank President Jens Weidmann aired his concerns in a letter to Draghi last month. Juergen Stark, the ECB's influential former head of economics, added his criticism by telling a German newspaper on Thursday that the quality of the central bank's balance sheet was now shocking.
Stark was one of two German members of the ECB policymaking fraternity who quit last year in protest at policies they felt overstepped the central bank's remit. Draghi denied there were any split this time.
My personal relationship with Jens is excellent ... Nobody is isolated in the Governing Council and especially the Bundesbank is not isolated, he said. I really cherish the culture and the tradition of the Bundesbank.
In his letter, which was leaked to the conservative German newspaper Frankfurter Allgemeine Zeitung on the day of the ECB's second dose of three-year funds, Weidmann wrote about the imbalances in the euro zone's payment system, TARGET2, and the resulting risks for the Bundesbank, which would be exposed in the unlikely event of the euro zone breaking up.
Draghi has played down those concerns and refused to comment on the progress of a deal between Greece and its private creditors designed to lower its debt, which closes later on Thursday.
Greece's private creditors must decide by Thursday evening whether they take part in the debt swap that is a key part of Greece's new 130 billion euro bailout package. Failure to secure the deal may put the rescue package at risk and open up the threat of a chaotic debt default of Greece.
That, unlikely as it now looks, would force the ECB firmly back into crisis-fighting mode.
(Writing by Mike Peacock. Editing by Jeremy Gaunt.)