ECB surprises with rate cut, cautious on bond buys

FRANKFURT Thu Nov 3, 2011 3:12pm EDT

The European Central Bank President Mario Draghi reacts during his first news conference in Frankfurt, November 3, 2011. REUTERS/Alex Domanski

The European Central Bank President Mario Draghi reacts during his first news conference in Frankfurt, November 3, 2011.

Credit: Reuters/Alex Domanski

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FRANKFURT (Reuters) - The European Central Bank cut interest rates by a quarter point to 1.25 percent in a surprise move on Thursday and President Mario Draghi said the euro zone could subside into a "mild recession" in the latter part of 2011.

The Italian has walked into a maelstrom in his first week at the ECB's helm, with euro zone leaders contemplating a future without Greece and economic policy paralysis in his home country threatening to pitch Rome into the storm.

But he offered no commitment to scale up the central bank's bond-buying program to support the likes of Italy and Spain, instead describing the purchase plan as "limited."

"What we are observing now is ... slow growth heading toward a mild recession by year-end," Draghi told a news conference at which he used some of his predecessor Jean-Claude Trichet's lines, while mixing in a dash of humor in an assured debut.

"A significant downward revision to forecasts and projections for average real GDP growth in 2012 (are) very likely," he added.

The rate cut, which Draghi said was a unanimous decision by the ECB's 23-member Governing Council, gave a boost to stock markets. The FTSEurofirst 300 index of top European shares closed up 1.9 percent.

A Reuters poll of 51 economists conducted after the rate move showed there is a 50-50 chance the ECB will cut interest rates again before the end of 2011.

The decision came despite inflation in the 17-country euro zone staying at 3.0 percent for a second month running in October, well above the ECB's target of just below 2 percent.

Draghi said the ECB expected inflation to subside below 2 percent next year, with wage and cost pressures abating as economic demand evaporated.

"We expect another rate cut to follow in December and there is a clear risk of the main policy rate breaking below 1 percent next year," JP Morgan economist David Mackie said.

While the ECB shocked markets with the rate cut, Draghi took a much more conservative stance on the bank's bond-buy program, which has come into increasing focus as Greece's uncertain future in the euro zone deepens the bloc's crisis.

European leaders said earlier they were prepared for Greece to leave the euro zone to preserve their 12-year-old single currency if Athens does not decide quickly to implement a bailout program, putting the likes of Italy and Spain, and even France, firmly in the markets' sights.

Europe's ultimatum to Greece, after Prime Minister George Papandreou's attempt to call a referendum on a bailout plan, has raised pressure on the ECB, which many analysts see as the only institution with the firepower to bring calm.

When asked about a possible Greek exit from the common currency bloc, Draghi said such an option was not in the treaty.

NO SHIFT ON BOND BUYING

Draghi gave no hint that the ECB's bond-buy program, a controversial tool that has led to the resignation of two German policymakers, would be accelerated despite the chaos in Greece threatening to engulf the much larger economies of Italy and Spain.

"Our securities market program has three characteristics: it is temporary; it is limited; it is justified in restoring the functioning of monetary transmission channels," he said.

Draghi succeeded France's Trichet as ECB chief on Tuesday -- a day that saw the ECB buy Spanish and Italian bonds but barely manage to cap a rise in yields on the debt of the euro zone's third largest economy.

He said the ECB had not been focusing on Italian bond yields and stressed that the bank would "not be forced by anybody" to buy bonds. He said it was pointless to think sovereign bond yields could be brought down for a protracted period by outside intervention.

"Here Draghi took a very conventional stance," Mackie said in a research note, noting that he also dismissed the idea of the ECB being a lender of last resort.

Trichet had signaled previously that the ECB was keen to withdraw from the bond-buying policy once the euro zone's EFSF rescue fund gained new powers to intervene on bond markets.

Draghi must balance an eagerness to curry favor with the German contingent at the ECB against growing financial market pressure to intervene on a bigger scale to lower the borrowing costs of Italy and Spain.

Many in Germany, where the legacy of hyperinflation in the 1920s has left people with a strong aversion to price rises, are concerned about an Italian taking over the ECB presidency.

Draghi sought to reassure Germans, saying he had "great admiration for the tradition of the Bundesbank," the German national central bank on which the ECB is modeled.

"As for the future, let me do my work and we will have periodic checks whether I am in sync with that tradition or I deviate from that," he said.

(Additional reporting by Paul Carrel and Sakari Suoninen; Editing by Mike Peacock)

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Comments (2)
BehG. wrote:
If the economies of today were driven by fundamentals and macro conditions, this would have been great news. However, it’s the banks that are now driving macro conditions and the bigger the spread between ECB rates and the rates offered by PIIGS, the more likely the banks will add these bad investments to their portfolios.

They know very well that the Europeans are doing eveything in their power to protect these bonds. In other words, these large spreads, actions of the ECB and Euro politicians are creating the exact conditions that led to the financial crisis in the first place – not to mention that we had a similar situation before the Great Depression.

You can not help free-market capitalism by introducing policies that remove balancing mechanisms that the market itself should determine.

Nov 03, 2011 9:33am EDT  --  Report as abuse
paulos wrote:
Meanwhile the banks that are within the Euro zone are selling bonds from Euro zone countries as fast as they can! They know what the future holds and want to reduce their exposure as far as possible. Not surprisingly Sarkozy wanted to avoid this in France and to keep it as quiet as possible.

Nov 03, 2011 12:27pm EDT  --  Report as abuse
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