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ECB cuts rate, tempers hopes for bigger bond buys

By David McHugh
AP Business Writer / December 8, 2011
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FRANKFURT, Germany—European Central Bank President Mario Draghi disappointed financial markets Thursday by keeping them guessing about whether the bank is willing to take aggressive action to bail out heavily indebted euro countries.

But in a sign of rising concern about Europe's debt crisis, the ECB cut its benchmark interest rate by a quarter point to 1 percent and announced several steps to bolster the continent's economy and financial system.

The actions didn't impress markets. Stocks and the euro fell heavily, while borrowing costs for European governments rose.

Based on comments Draghi made in a speech last week, hopes had been rising that the ECB was prepared to ramp up its purchases of European government bonds as the eurozone economy slides toward recession. But on Thursday, he said the bank had no explicit plan to do so and was "surprised" by the way his remarks had been interpreted.

Speaking at a news conference after the rate decision, Draghi said the notion of the eurozone being broken apart by its worsening debt crisis was "far-fetched." He stressed that market confidence in the 17 countries that use the euro would rise if leaders at a European Union summit in Brussels agree to a credible plan to enforce budget discipline.

Such a plan is "the most important precondition for restoring the normal functioning of financial markets," Draghi said.

Draghi, a former head of the Italian central bank, became president Nov. 1 and announced a rate cut at his first policy meeting two days later. In five weeks on the job, Draghi has begun to recast the image of the ECB, which until recently had been deemed too timid to save the euro.

Markets are still trying to figure out how much his policies might depart from his predecessor, Jean-Claude Trichet. Trichet was regarded by some as an overly rigid interpreter of the bank's anti-inflation mandate enshrined in the European Union treaty. He has been criticized by some economists as too slow to cut rates during the Great Recession -- and then too quick to raise them afterward, as the bank did twice earlier this year.

Draghi's actions over the past five weeks are seen as a sign of both a more pragmatic approach and of Europe's deteriorating financial condition.

Aside from the rate cut, the ECB announced other measures intended to stimulate lending and investing and bolster Europe's financial system:

-- It said banks could tap unlimited credit for up to 36 months and that it would loosen rules on collateral for these loans by accepting lower-rated mortgages and bank loans. Previously, the credit had been available for no more than about a year. Extending the term is meant to reassure markets that banks will have financing for at least three years.

-- It also reduced the amounts banks must hold in reserve with the ECB, helping them bolster their finances.

Analysts said the rate cut would help, but they had hoped for more. "I thought they'd be more aggressive and cut by 50 basis points because the economy looks like it's heading for recession and the banking sector is facing big pressures," said Neil MacKinnon, global macro strategist at VTB Capital. In the U.S., by contrast, the Federal Reserve pushed short-term interest rates to zero in December 2008 and kept them there.

Large-scale bond purchases in the open market would help drive down yields on government bonds. That would reduce borrowing costs for heavily indebted countries such as Italy and Spain, Europe's third- and fourth-largest economies.

By stabilizing the finances of Europe's governments, the ECB would then strengthen the continent's financial system. European commercial banks are holding Italian and Spanish bonds that have plunged in value because of fears of government defaults. As a result, banks have become too nervous to lend to each other. That credit squeeze is being felt globally.

European commercial banks that own government bonds face potentially huge losses and, as a result, they have curtailed lending to each other, banks and consumers. That credit squeeze is felt globally.

But Draghi's comments Thursday frayed the nerves of markets. Germany's DAX stock index dropped 2 percent, while Italy's FTSE MIB index dropped 4 percent. In the U.S., the Dow Jones industrial average fell 0.9 percent, with shares of JPMorgan Chase declining 2.4 percent.

The yield on the benchmark 10-year Italian government bond jumped a quarter of a percentage point, a large move, to 6.12 percent. The yield on Spain's 10-year bond rose one-third of a percentage point to 5.71 percent.

"Investors who had been expecting some kind of great immediate action that was going to fix things are starting to get nervous," said Fred Cannon, chief equity strategist at the investment firm Keefe, Bruyette & Woods.

Other analysts took a more sanguine view of Draghi's comments, saying he did not shut the door to further intervention but rather sought to put more pressure on EU leaders in Brussels.

"To some degree Draghi had no choice but to dampen hopes for more bond purchases, as otherwise he would have taken away pressure on the EU summit to decide on the necessary reforms of the currency union," Joerg Kraemer, the chief economist at Commerzbank, said.

On Dec. 1, Draghi urged European leaders to agree on "a fiscal compact" that would prevent eurozone governments from piling up too much debt and punish violators. He then said: "Other elements might follow."

Analysts say the ECB has several options to intervene more forcefully. It could: tell markets that it won't permit Italian and Spanish bond yields to stay above, say, 5 percent; ramp up its purchases of government bonds without an announcement; or issue a more vague statement that it stands ready to support governments.

One option Draghi dismissed was the possibility of the ECB lending to the International Monetary Fund, so that it could bail out European governments. "If the IMF were to use this money exclusively to buy bonds in the euro area, we think it's not compatible with the treaty."

By cutting its benchmark rate on short-term loans to banks, the ECB intends to lower the cost of credit throughout the economy, making it cheaper for businesses and consumers to borrow and spend. In the third quarter, economic growth in the eurozone was a meager 0.2 percent. Many economists believe the region's economy will shrink in the fourth quarter.

Lower interest rates can also push prices and wages higher. The fear of stoking inflation was a major reason why the ECB had been cautious about lowering rates earlier this year. But many economists say that with Europe likely headed for a mild recession, and possibly worse, the greater danger on the horizon is deflation, or falling prices and wages.

Inflation was running at an annual rate of 3 percent in October. That's above the bank's stated goal of just under 2 percent. But the bank forecasts it will fall in coming months.

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