European Central Bank Set to Cut Interest Rates and Announce Other Measures at May 7 Policy Meeting

Crucially, Trichet also revealed that the ECB is poised to announce further "non-standard" measures at its May policy meeting. He reported that the ECB is "examining all elements" to enhance credit support and that the bank "are in full-fledged non-standard measures."

Recent developments have broadly strengthened the case for further ECB action at next Thursday's policy meeting. It seems highly likely that Eurozone GDP contraction in the first quarter of 2009 was even deeper than the 1.6% quarter-on-quarter drop suffered in the fourth quarter of 2008. There are indications that the rate of economic contraction is now beginning to moderate, but it is currently still substantial and any recovery still seems some way off.

Furthermore, latest data from the ECB suggests that credit conditions are still tightening, which is damaging to economic activity and a threat to recovery prospects.

Meanwhile, Eurozone consumer price inflation remained at 0.6% in April, having previously plunged to this level in March from 1.2% in February and a peak of 4.0% in mid-2008. This is substantially below the ECB's target level of "close to, but just below, 2.0%." Furthermore, it seems highly likely that inflation will come down significantly further over the coming months.

Indeed, a brief period of deflation remains very possible later this year and there is a very real possibility that Eurozone consumer price inflation will substantially undershoot the ECB's target level for an extended period. Although oil prices have come off their lows earlier this year, they remain massively below the peak levels of US$147/barrel seen last July, so base effects will remain favourable in the near term. Furthermore, underlying inflationary pressures continue to be diluted as the deep recession hits companies' pricing power hard and widens output gaps. Meanwhile, sharply rising unemployment is pushing down on wages.

We expect the ECB to trim its key interest rate by a further 25 basis points from 1.25% to 1.00% at its May 7 meeting. It is possible that the ECB could eventually bring the interest rate down below 1.00%, but there currently still appears to be strong opposition to such a move within the bank and it looks likely that the ECB will increasingly focus on "non-standard" measures to boost economic activity.

This is most likely to include an announcement on Thursday that it will lend funds to banks at fixed interest rates for longer terms than the current six months. There is significant speculation that the ECB could also announce that it is to start purchasing assets, with bonds issued by banks considered to be among the most likely options.