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ECB cuts key rate at Draghi's debut

By David McHugh
AP Business Writer / November 3, 2011

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FRANKFURT, Germany—Mario Draghi made his debut as head of the European Central Bank with a surprise interest rate cut to boost a eurozone economy hit hard by turmoil from the Greek debt crisis.

The quarter percentage-point cut takes the bank's main interest rate down to 1.25 percent in an attempt to boost confidence in the 17 countries that use the euro and prevent an expected slowdown in the last three months of the year from turning into an outright recession.

But while he began his eight-year term with a dramatic anti-crisis measure, Draghi gave a sharp rebuff to anyone expecting more help from another direction: the bank's controversial program to buy government bonds.

The point of the purchases, which are intended to keep the Greek crisis from spreading to much bigger euro economies like Spain and Italy, is to drive down the borrowing costs for those countries. The program has kept Europe from a financial meltdown since August but its critics say it takes the pressure off governments to act responsibly.

Draghi said the program remains "temporary" and added that it was "pointless" for governments to rely on the central bank. A far better way to relieve the interest rate pressure is for countries to get their deficits under control and boosting growth, he said.

The rate cut, which comes earlier than expected by many economists, rolls back an increase made under predecessor Jean-Claude Trichet only in July. Economic forecasts have worsened significantly since then.

"It is obvious that the ECB has caught the crisis virus and is trying everything it can to prevent a full-fledged recession," said economist Carsten Brzeski at ING.

Uncertainty from Europe's debt crisis is a factor as business and consumers are reluctant to spend, while investors are worried of the potential for more financial turmoil if Greece defaults on its debts. Banks, who typically hold government bonds, have cut back on lending to businesses.

At his first post-meeting news conference, Draghi said the current market turbulence is "likely to dampen the pace of economic growth in the second half of the year and beyond."

A slowing economy means, in turn, that inflation would drop next year from its current 3 percent to the bank's goal of less than 2 percent. The bank's main mission is controlling inflation, so it needs to see that prices are under control before cutting rates, which can worsen inflation.

Draghi noted there were significant downside risks for growth, and that "some of those risks are materializing."

The cut will shore up confidence at a time when Europe is embroiled in a crisis stemming from Greek Prime Minister George Papandreou's pledge to hold a referendum on the country's latest bailout package.

The referendum has now been scrapped, but the uncertainty over Greece will likely linger.

Eurozone officials were horrified when Papandreou's proposal threatened to unravel a Greek bailout and debt reduction deal arrived at only last week. It comes with painful budget cuts and Papandreou's sudden proposal raised the prospect of a disorderly debt default by Greece and rising interest rates for other countries as investors feared they may end up in the same position.

The euro130 billion package of bailout credit for Greece includes an agreement that banks will write off 50 percent of their holdings of Greek bonds. The other two pillars of last week's much-trumpeted eurozone rescue package included a bank recapitalization plan and new powers for the eurozone's bailout fund to backstop Italy and Greece.

But arrangements to increase the financial firepower of the bailout fund through leverage -- by having it insure part of government borrowing -- or by attracting outside investors have not been worked out yet.

That has left the ECB as the last firewall keeping Italian and Spanish rates from rising so much they can no longer borrow.

It's a role Draghi's predecessor, Jean-Claude Trichet, assumed only reluctantly and was eager to hand off.

On Thursday, Draghi indicated that wouldn't change.

"It is pointless to think sovereign bond rates could be brought down for an extended period of time by outside interventions," he said.

He also rejected any expansion of the bank's role under the EU treaty to serve as a lender of last resort to governments. He said the bank's remit was "enshrined" in the treaties, which bar lending to governments.

"We have to have full respect of the spirit and the letter of the treaties," he said.

The issue is pressing, with Italian bond yields standing at an elevated 6.3 percent.

The ECB purchase program had driven them under 5 percent in August but fears of more turmoil in Greece, and a perception that Italy is not acting quickly to cut spending and improve growth have put more pressure on its bonds. Bond yield rise as their prices fall.

Draghi said the only solution was "the countries' capacity to reform themselves with the right economic policies."

Joerg Kraemer, chief economist at Commerzbank, said circumstances could eventually force Draghi to change his stance since the bailout fund is too small to rescue Italy. A financial collapse by Greece, he said, would force someone to rescue Italy -- and right now only the ECB could do that, possibly by the drastic step of creating new money.

"Today's surprise interest rate cut does at least not contradict our assumption that, if worst came to worst, the ECB would buy far more government bonds than many people currently imagine even if this meant funding government expenditure by printing money on a large scale, something which would damage its credibility and go against the spirit of its status," Kraemer wrote in an analysis.

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