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Euro zone inflation plunges, hits euro on ECB cut view

Euro zone inflation plunged more than expected to a 26-month low in December, data showed on Tuesday, pulling the rug from under the euro on rising expectations of a deep European Central Bank rate cut next week.

The European Union's statistics office Eurostat said inflation in the 15 countries using the euro in December was 1.6% year-on-year, down from 2.1% in November and well below the ECB target of just under 2%.

Economists polled by Reuters had expected a decline to 1.8%. The euro plunged against the dollar to $1.3369 from $1.3440 in response.

The estimate does not contain a monthly figure or a detailed breakdown, but economists said the fall stemmed mainly from a sharp drop in oil prices compared to the same period of 2007.

“It makes it even more likely for the ECB to cut interest rates further in the next few months, starting in January and going to 1.5% in March,” said Holger Schmieding, co-head of Europe economics at Bank of America.

“Next week, the cut will probably be 50 basis points,” he said.

The ECB meets to discuss rates on January 15. Markets have largely priced in a 50 basis point cut, with some investors betting on a 75 basis point move after the last such reduction in December.

The bank has cut rates by 175 basis points to 2.5% since October as inflation decelerated rapidly from a July peak of 4.0% along with a sharply slowing economy and falling oil prices.

“The balance of news from Europe is so poor that the market is perceiving that the ECB is behind the curve (on rates),” he said Adam Cole, global head of currency strategy at RBC in London.

ECB President Jean-Claude Trichet has declined to give any firm indication on whether such rate cut bets are justified.

But ECB Governing Council member Vitor Constancio said on Monday the bank would respond with more rate cuts if necessary to keep inflation from falling too much below target.

And ECB Vice-President Lucas Papademos said on Sunday that more rate cuts may be needed to shield the euro zone economy and make sure inflation did not fall too far, stressing that deflation would be kept at bay. (Reuters)