The European Central Bank (ECB) opened the door yesterday to its first cut in interest rates in more than five years, conceding that inflationary dangers have faded as financial turmoil saps the strength of the eurozone economy.

The Frankfurt institution fulfilled market expectations to keep eurozone rates pegged yesterday at a seven-year high of 4.25 per cent for a third month in succession.

However Jean-Claude Trichet, the ECB’s President, signalled that it is now preparing the ground for a reduction in the eurozone’s official borrowing costs. Markets are betting that the ECB will act to cut rates as soon as next month.

Mr Trichet said that the convulsions across financial markets in the past two weeks had created great uncertainty over economic prospects, and that there was clear evidence that the eurozone was now faltering.

These factors had reduced, although not eliminated, the threat to the outlook in the 15-nation bloc from inflation, he argued. “Upside risks to price stability have diminished somewhat, but they have not disappeared,” he said.

The ECB’s rate-setting Governing Council had considered cutting interest rates this month but had opted to defer any action, he added.

“We had examined two options — to keep interest rates unchanged [and] the other one [was] decreasing interest rates,” Mr Trichet said. “Our conclusion is that we were right in keeping interest rates as they are.”

Economists said that it was clear that the ECB was paving the way to cut rates in the near future, while markets reached the same conclusion, sending the euro tumbling to its lowest in almost 13 months against the dollar.

Nick Matthews, of Barclays Capital, said: “It is clear that the ECB will be lowering rates and the main question is whether it will be in November or December. We think it will be next month.”

A cut in interest rates this year would be the first for the eurozone since June 2003 and would mark a rapid about-turn by the ECB, which last raised rates as recently as July, as it sought to rein in soaring inflation.

Figures earlier this week showed that eurozone inflation eased a little, to an annual pace of 3.6 per cent, last month, although this remains far above the ECB’s target of “close to, but below, 2 per cent”.

Mr Trichet emphasised how the economic landscape was being transformed by the present financial upheavals. “Nothing in the past resembles what we are currently seeing. We are in the presence of events that we have not seen since World War Two. We must review absolutely all the elements of the financial system to ensure this does not happen again.”

The threat that leading economies on both sides of the Atlantic will suffer severe recessions after the market traumas was underlined by new research from the International Monetary Fund (IMF).

A study of 113 episodes of financial stress in 17 countries over 30 years found that where turmoil was linked to distress in the banking sector, such upheavals were much more likely to be followed by protracted economic downturns.

Charles Collyns, deputy director of the IMF’s research department, said: “It is now all too clear that we are seeing the most dangerous shock to mature financial markets since the 1930s. To limit the fallout, it is of paramount importance that the damage to banking systems in the United States and Europe is swiftly contained by far-reaching and comprehensive measures.”

In an ominous warning for the US and Britain that the impending downturn could be most severe for their economies, the IMF analysis also found that recessions after banking crises were worst where they followed a period of rapid credit growth, heavy borrowing by households and businesses, and soaring house prices. All those conditions have been seen in the US and UK, but not in the eurozone.

There was also backing from the IMF for early interest rate cuts in Britain, the eurozone and the US. In a second study it concluded that although global factors were likely to keep commodity prices at historic highs in coming years, inflationary risks to big, developed economies were disappearing, “owing to the deflationary impact of the financial turmoil”.

Three-month rates rise

Stress in world money markets continued to intensify despite huge injections of short-term funding by central banks.

Lending costs for overnight borrowing between banking groups eased, with interbank rates for overnight dollars dropping a full point to 2.68125 per cent.

Three-month interbank rates rose again, however. The cost of three-month dollars jumped to 4.20750 per cent, its highest since January, while the gap between three-month dollar rates and expected future US official rates rose to its highest since the credit crisis began a year ago.

Three-month euro rates also rose to 5.31750, the highest since the inception of the single currency in 1999.

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