ECB Leaves Rates Unchanged

Central bank refrains from action despite clamor for further stimulus.

The European Central Bank refrained from cutting interest rates as President Mario Draghi faces pressure to reduce bond yields to protect the euro.

Policy makers meeting in Frankfurt today left the benchmark rate at a record low of 0.75 percent, as predicted by 51 of 55 economists in a Bloomberg News survey. Four predicted a cut to 0.50 percent. The deposit rate was held at zero. Draghi holds a press conference at 2:30 p.m. in Frankfurt.

Investors and politicians are clamoring for ECB action to quell Europe’s sovereign debt crisis, which is threatening to cripple Spain and Italy and splinter the 17-nation monetary union. While Draghi signaled in London last week that he’s prepared to intervene in bond markets to reduce soaring borrowing costs, he may face resistance from Germany’s Bundesbank.

“Draghi will announce more measures during the press conference,” said Jacques Cailloux, chief European economist at Nomura International Plc in London. “If they don’t start bond purchases now, it’ll happen pretty quickly. They won’t be able to tame markets solely via rhetoric and will need to put actions behind words.”

The Federal Reserve yesterday pledged to take new policy steps as needed to promote stronger economic growth and employment. The Bank of England today held its key rate at 0.5 percent and maintained its bond-purchase target at 375 billion pounds ($586 billion).

Draghi’s pledge to act has fueled a global market rally, taking Spain’s 10-year bond yield down to 6.65 percent today from 7.75 percent on July 25. It is still 530 basis points above the German equivalent.

“To the extent that the size of these sovereign premia hamper the functioning of the monetary policy transmission channel, they come within our mandate,” Draghi said on July 26. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

Having fueled expectations to such an extent, “Draghi is hardly likely to want to appear empty-handed,” said Christoph Balz, an economist at Commerzbank AG in Frankfurt. “But none of the options are easy to implement. Perhaps Draghi will pull a new rabbit out of the hat.”


Seeking Consensus

In the past week, Draghi has canvassed support among ECB council members and politicians for a multi-pronged approach to reduce yields, two central bank officials with knowledge of the discussions said on July 27.

Draghi proposes that Europe’s rescue fund buy government bonds on the primary market, flanked by ECB purchases on the secondary market to ensure transmission of its interest rates, the officials said on condition of anonymity. Further ECB rate cuts and long-term loans to banks were also up for discussion as the euro economy slides toward recession, one of the officials said.

While the leaders of Germany, France and Italy have appeared to endorse Draghi’s plan, echoing his language in saying they will do whatever is necessary to protect the euro, significant hurdles remain.

For the rescue fund to buy sovereign debt, the government in question must make a formal application, and any aid would carry conditions. Spain has no intention of making such a request, Treasury head Inigo Fernandez de Mesa said July 30.

“Draghi therefore finds himself in an awkward position,” said Ken Wattret , chief euro-zone economist at BNP Paribas SA in London. “Either he will disappoint market expectations relative to what was said last week or alternatively, the ECB will have to fly solo and re-start the SMP.”

The ECB’s bond-buying instrument, the Securities Markets Program, has been dormant since March.

The day after Draghi spoke in London, the Bundesbank reiterated its opposition to ECB bond purchases, saying they blur the line between fiscal and monetary policy. Draghi planned to hold talks with Bundesbank President Jens Weidmann this week in an attempt to find common ground, the two central bank officials said.

The ECB shouldn’t overstep its mandate, Weidmann said in a June 29 interview posted on the Bundesbank’s website yesterday. Weidmann attended today’s ECB council meeting, a Bundesbank spokesman said.


Other Options

Another option is for the ECB to purchase bank and corporate bonds to ease financing conditions, said Huw Pill, chief European economist at Goldman Sachs International in London. Pill expects the ECB to allow national central banks to buy such assets at their own risk, which would “offer scope for surgical interventions targeted to address the most impaired elements of monetary policy transmission,” he said in a note to clients on July 29.

Policy makers could also decide to offer banks another batch of long-term loans, known as Longer Term Refinancing Operations. Bond yields declined after the ECB flooded markets with more than 1 trillion euros ($1.23 trillion) of cheap three-year loans in December and February as banks in Spain and Italy used the funds to purchase the debt of their governments.

“The ECB has been emphasizing that it has yet to evaluate the full impact of the previous LTROs, making another one less likely in the short term,” said Athanasios Vamvakidis, head European currency strategist at Bank of America Merrill Lynch in London. If it does opt for such a measure, the bank may have to complement it with looser collateral requirements, he said, adding that lowering haircuts on asset-backed securities could free up as much as 100 billion euros of additional collateral.

Economists said one grand solution to the crisis is unlikely to be announced today: giving Europe’s permanent bailout fund, the European Stability Mechanism, a banking license. That would allow the 500 billion-euro ESM to borrow from the ECB, boosting its firepower.

“A banking license for the ESM or open-ended purchases of government bonds would violate the ECB’s prohibition of deficit financing,” said Tobias Blattner, an economist at Daiwa International in London. “This is likely to be one of the most important press conferences in the short history of the ECB. But market expectations have gone well beyond realism.”


 Bloomberg News


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