ECB keeps rates unchanged, policy measures eyed

European Central Bank President Mario Draghi was under intense pressure from investors, European leaders and even the United States to deliver on Thursday on his pledge to do whatever it takes to save the euro.

The central bank decided at its monthly policy meeting to keep interest rates on hold at 0.75 percent, but financial markets were waiting for Draghi’s news conference 8 to see what plans may be afoot to bring Italian and Spanish borrowing costs down to more affordable levels.

“This was not a surprise,” Rabobank economist Elwin de Groot said of the rate decision. “It is much more important to see what other measures they might have decided.”

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Any sign that Draghi overplayed his hand when he made the bold pledge a week ago could see markets punish the euro zone.

[caption id=“attachment_402432” align=“alignleft” width=“380”]  ECB action is hamstrung by EU rules forbidding it from financing governments. Reuters[/caption]

His comments in London last Thursday that the ECB would do whatever it takes within its mandate to protect the currency bloc from collapse - “and believe me, it will be enough” - have already eased tensions on the debt markets.

Reuters reported on Monday the main idea under consideration by the ECB is re-activating its bond-buying program for Spain and Italy in tandem with the euro zone’s rescue funds, but that action could be at least five weeks away.

Spain sold the 10-year bonds at an average yield of nearly 6.65 percent - a rate analysts say remains uncomfortably high, although it was down from a 7.64 percent peak last week.

The rise in Spanish borrowing costs is forcing euro zone policymakers into bolder action than they have taken before.

Finnish Prime Minister Jyrki Katainen told an Italian newspaper European leaders were preparing for the euro zone’s rescue funds to buy bonds on primary market for two years, with a decision likely in September.

EXPECTATIONS DASHED

Katainen told Italian newspaper La Stampa: “We will make our proposal in September. So far what has been discussed has been using the ESM to buy bonds of countries in trouble on the secondary market, but I don’t think that’s the right solution.”

“We have to find the way to use the (ESM) more efficiently, for example by buying state bonds on the primary market. That would go straight at the problem, lowering spreads more strongly,” the Finnish leader told another Italian newspaper, La Repubblica.

Other countries, especially the United States, have raised pressure on the ECB to act as the two-and-a-half year old euro zone crisis weighs on global growth.

The U.S. Federal Reserve dashed expectations among some investors on Wednesday by taking no immediate new measures to revive the economy.

The Fed stopped short of offering new monetary stimulus, though it signaled more strongly that further bond buying could be in store to help a U.S. economic recovery that it said had lost momentum this year.

The ECB has already bought government bonds through its Securities Markets Programme (SMP), spending more than 210 billion euros on them so far. Re-employing the existing tool would avoid legal battles that any novel measures could face.

While the SMP is widely viewed as having had very limited success, it is at least available immediately and could be used in a new form, combining it with the euro zone’s temporary EFSF and permanent ESM bailout funds.

The ECB could use the SMP to buy bonds once Spain makes a formal request for assistance and signs up to a reform programme with international monitoring.

A revival of ECB bond buys was seen as the most likely option in a Reuters poll of money-market traders.

“Based on Draghi’s comments a restart of SMP buying appears the most likely response,” Danske Bank’s Allan von Mehren and Anders Moller Lumholtz said in a note.

Another option for a quick start, suggested by Goldman Sachs economist and former senior ECB official Huw Pill, would be for the ECB to let national central banks buy private-sector assets in targeted operations to ease credit availability.

GERMAN OBSTACLE

ECB action is hamstrung by EU rules forbidding it from financing governments. The ECB issued a legal opinion in March 2011 ruling out perhaps the biggest gun, giving the ESM bailout fund rights to tap the ECB for funds to increase its firepower.

The ECB has to find a way to get any measures past Germany, the euro zone’s largest economy and its principal paymaster. The Bundesbank issues regular reminders of inflationary dangers stemming from non-standard measures such as bond purchases and the limits central banks face.

Former ECB chief economist Juergen Stark, a German who quit last year in opposition to bond-buying, kept up the pressure even as the ECB met, telling N-TV television: “The central bank is not a money printing machine to solve the problems of the real economy and the problems that some countries have.”

The dilemma for Europe is that too little action now could create bigger problems later. If borrowing costs don’t come down and Spain and Italy are forced to seek bailouts, the ESM’s 500 billion euro capacity would soon be exhausted, and it would need more funds.

ON HOLD

The ECB lowered the main rate to a record low of 0.75 percent in July. A Reuters poll showed that economists expect another cut before the end of the year, but only seven out of 70 had expected it this month. The bank also kept its deposit rate, which acts as a floor to money markets, at zero.

News on Thursday of a bigger-than-expected fall in eurozone factory prices in June kept the ECB’s options open for a further rate cut later this year.

As the crisis has intensified, the euro has weakened in foreign exchange markets. It has fallen about 15 percent in the past year to trade around $1.23. On a trade-weighed basis it trades at nine-year lows.

The falling euro is good for European exports but is likely to delay the day when inflation falls below the ECB’s target of 2 percent. In July, it remained at 2.4 percent. It also assuages fears of deflation, a spectre that could otherwise have prompted the ECB to consider large-scale bond buying.

“To move into large-scale asset purchases from purely monetary stance motivation will take a while,” JP Morgan economist David Mackie said. “It’s certainly not going to happen … until we get into next year.”

Reuters