FRANKFURT – The euro zone economy is likely to shrink next year as it has in 2012, the European Central Bank predicted on Thursday, sharply downgrading its outlook after holding interest rates at a record low 0.75 percent.
The bank's new staff projections put gross domestic product in a range of falling by 0.9 percent to growing by just 0.3 percent next year, suggesting contraction is far more likely than not. ECB President Mario Draghi said downside risks prevailed.
In September, the ECB's staff had penciled in a significantly higher range of -0.4 to +1.4 percent for the euro area economy.
"Economic weakness in the euro zone is expected to extend into next year," Draghi told a news conference after the central bank's monthly policy meeting.
"Later in 2013, economic activity should gradually recover as global demand strengthens and our accommodative monetary policy stance and significantly improved financial market confidence work their way through the economy."
The Governing Council's decision to leave its main interest rate unchanged matched economists' expectations in a Reuters poll, which also showed opinion was split down the middle over the chances of a cut early next year.
"The Governing Council continues to see downside risk to the economic outlook for the euro area," Draghi said. "These are mainly related to uncertainties about the resolution of sovereign debt and governance issues in the euro area."
A political impasse over the United States' fiscal policy, which could presage steep tax hikes and budget cuts if a deal is not reached, could also dampen sentiment for longer, he said.
The level of uncertainty was reflected in the ECB's first attempt to forecast 2014, for which it penciled in growth of between 0.2 and 2.2 percent. The midpoint forecast for 2012 was pushed slightly lower to -0.5 percent.
Draghi said rates were not lowered because of high indirect taxes and increasing energy prices in some euro zone countries.
"There was a wide discussion ... but the consensus was to leave the rates unchanged," he said, a hint that opinions differed about what course to take.
He also said the policymakers discussed setting a negative rate on the ECB's deposit facility in an attempt to encourage banks not to hoard cash at the ECB but lend it into the real economy instead.
German Bund futures rose in response to that and the euro came under pressure.
The ECB will also continue to supply euro zone banks with all the liquidity they ask for in the central bank's refinancing operations at least until July 2013, Draghi said.
WAITING FOR SPAIN
While financial markets have calmed since the European Union and the International Monetary Fund put in place further steps to help Greece, and the ECB promised to do what it takes to preserve the euro, the bloc's economy has sunk into recession from which it shows few signs of emerging soon.
An inflation forecast of 1.1 to 2.1 percent next year -- compared with the ECB's target of close to but below two percent -- there would appear to be plenty of room to cut rates further.
But recent policymakers' comments have suggested the ECB is unlikely to do so in the near future and the central bank is wary of taking any action that could see the bloc's governments soft-pedal on budget consolidation efforts.
Also, market interest rates vary greatly across the 17-country bloc and the ECB is focused on fixing what it calls the 'transmission mechanism' for passing on its rates to all corners of the euro area before contemplating lowering official borrowing costs.
The most obvious mechanism for doing that would be the ECB's yet to be used new bond-buying scheme, which could drive down government borrowing costs.
The ECB has not yet bought any sovereign debt under its new program -- dubbed Outright Monetary Transactions (OMT) -- because Spain, which is seen as most likely to become the first country to make use of the new support measure, has not yet fulfilled the precondition of asking for help from the euro zone's rescue fund.
Pressure for the ECB to intervene is building.
Spain auctioned fewer bonds than it hoped to on Wednesday as investors fret over the timing of an expected aid request by the government.
(Writing by Mike Peacock. Editing by Jeremy Gaunt.)