ECB Leaves Key Rate at 1.5%

Spread of debt crisis to Spain and Italy increases pressure on policy makers.

The European Central Bank left interest rates unchanged as economic growth slows and the region’s debt crisis spreads to Italy and Spain, increasing pressure on policy makers to resume bond purchases.

ECB officials meeting in Frankfurt today kept the benchmark rate at 1.5 percent after lifting it by 25 basis points last month, as predicted by all 54 economists in a Bloomberg News survey. With yields on Italian and Spanish bonds near euro-era records and the economy showing signs of weakening, investors have reduced bets that the ECB will add to its two rate increases in 2011, even as some Governing Council members push for more monetary tightening to tame inflation.

“Economic growth has gone beyond moderation -- in fact we’re flirting with recession -- and financial market tensions have intensified,” said Ken Wattret, chief euro-area economist at BNP Paribas SA in London. “The question is: Will there merely be a pause, or is the tightening cycle over?”

ECB President Jean-Claude Trichet holds a press conference 2:30 p.m. in Frankfurt. Separately, the Bank of England kept its key rate at 0.5 percent.


Greek Bailout
While European leaders last month agreed on a second bailout package for Greece that includes voluntary contributions from private-sector bondholders and widens the scope of the European rescue fund, investors aren’t convinced the measures will stop the 21-month debt crisis from spreading. Governments must still ratify the plan, which would empower the European Financial Stability Facility to start buying bonds on the secondary market.

The ECB, which ceased buying the bonds of distressed euro-area governments 18 weeks ago, may be forced to re-enter markets if Italian and Spanish yields keep rising, Royal Bank of Scotland economists Jacques Cailloux and Nick Matthews said. The central bank has bought 74 billion euros ($106 billion) of assets since May last year in an effort to ease market tensions.

“With the periphery crisis deepening, we expect the ECB to ultimately be forced to resume bond purchases before year-end with a size equivalent to an annualized rate of 1 trillion euros, at least as an interim measure until the EFSF is fully operational,” they wrote in a research note.


Currency Intervention
Europe’s debt crisis and concerns about slowing growth in the U.S. are starting to hurt other economies as investors seek havens, driving up their exchange rates and undermining exports. The Swiss central bank unexpectedly cut interest rates yesterday and said it will increase the supply of francs to money markets to stem the currency’s gains after it rose to records against the euro and the dollar.

Turkey’s central bank today reduced its benchmark rate to a record low of 5.75 percent to shield its economy. Japan sold yen to halt an appreciation that saw it approaching a postwar high against the dollar. The Bank of Japan also pledged to inject an additional 10 trillion yen ($126 billion) into the economy.

While the ECB has put the onus on governments to come up with a solution to Europe’s worsening crisis, soaring bond yields in the region’s third and fourth-largest economies are raising the stakes.

The yield on 10-year Italian bonds jumped to 6.26 percent yesterday, the highest since the introduction of the single currency in 1999, while the yield on Spanish 10-year debt surged to 6.46 percent this week. Yields retreated today.


Risk of Default
Credit default swaps imply a 27 percent chance that Italy will default on its debt within the next five years and a 31 percent probability that Spain won’t be able to meet its obligations.

“If the ECB didn’t re-activate its bond program in the last few weeks, it won’t do so now,” said Klaus Baader, chief euro-area economist at Societe Generale in London. “It would be harmful for the political discussion because governments may take it as reason to restrain potential interventions by the rescue fund.”

There are signs the debt crisis is starting to weigh on confidence in core euro-area economies such as Germany, where growth is already slowing as the global recovery falters. Investor sentiment dropped to a 2 1/2 year low last month and business confidence waned.

European services and manufacturing growth weakened in July to the slowest pace since the euro region emerged from recession two years ago. The ECB in June revised down its 2012 growth forecast to 1.7 percent from 1.8 percent.


Rate Forecasts
Investors have pushed back expectations for another ECB rate increase into next year, Eonia forward contracts show. While economists still expect the ECB to tighten borrowing costs again in October, according to the median of 33 forecasts in a July 29 survey, the number of those expecting no change in rates rose to 14 from 10 in the previous survey on July 1.

Euro-area inflation, which the ECB aims to keep just below 2 percent, slowed to 2.5 percent last month from 2.7 percent in June, driven by a sharp drop in Italy’s rate. M3 money supply growth, which the ECB uses as a gauge of future price pressure, also decelerated. At the same time, inflation in Germany unexpectedly quickened to 2.6 percent.

Bundesbank President Jens Weidmann said on July 7 that the ECB’s interest rates are “still relatively low,” indicating he sees room for further tightening. Fellow ECB council member Andres Lipstok of Estonia said on July 26 that focusing excessively on countries that have succumbed to the region’s debt crisis entails the “threat of price-rise acceleration in the entire euro area.”

“It might be a bit too early to see them significantly changing their language,” said Nick Kounis, head of macro research at ABN Amro NV in Amsterdam. “But if you look at the way things are going, there has to be some heightened probability now of a pause in rate hikes.”


Bloomberg News

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