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By Marc Jones
FRANKFURT, Nov 25 (Reuters) - European Central Bank Executive Board Member Lorenzo Bini Smaghi said there was no sign yet of deflation in the euro zone and warned against overly drastic interest rate cuts in response to the financial crisis.
"While a number of factors suggest that inflationary pressures will decline significantly, there are currently no signs of deflationary expectations." Bini Smaghi said in a speech in Venice on Tuesday.
"As long as inflation expectations remain firmly anchored, deflation will therefore remain a rather remote risk."
Economists view deflation -- a generalised, sustained fall in prices -- as a nightmare scenario where economies slump into a malaise as consumers and firms hold back on spending in the view that goods will become cheaper the longer they wait.
The prospect of constantly falling prices is particularly unwelcome at present given the blow it deals to efforts by banks, firms and households to cut debt and help weather the economic storm now following the financial market crisis.
Bini Smaghi said medium to longer term predictions still forecast euro zone inflation to be around the ECB's target zone of 2 percent and warned against overly drastic cuts to interest rates by central banks in the face of the current crisis.
"It may contribute to, rather than obviate, a worsening of market sentiment, if it is interpreted as a signal that the central bank has a more pessimistic assessment of the economy than market participants," he said.
"The exhaustion of all ammunitions earlier in the process, when there is no evidence of a deflationary shock, reduces the margin of manoeuvre in case other adverse shocks occur."
Two quick-fire 50 basis point cuts since October has seen the ECB reduce euro zone interest rates to 3.25 percent and analysts think they could be cut to 2 percent or lower if the region's current recession evolves into a major long term slump.
Financial markets see it as a virtual certainty that the ECB will slash rates by at least another 50 basis point when they next meet at the start of December but Bini Smaghi said the problems in the banking system were dulling the true benefits of the cuts.
"We can see that in the current environment rates to end users have fallen much less than policy rates. This undermines the confidence on the effectiveness of monetary policy."
He called for "decisive action" to repair to problems as soon as possible, adding it was "essential that the transmission mechanism of monetary policy is improved, so that monetary impulse is transmitted effectively to the real economy."
(Reporting by Marc Jones; Editing by Victoria Main)