ECB's Draghi to hold fire as euro crisis threatens to return

FRANKFURT Wed Jul 3, 2013 7:07pm EDT

European Central Bank (ECB) President Mario Draghi arrives at a European Union leaders summit in Brussels June 28, 2013. REUTERS/Francois Lenoir

European Central Bank (ECB) President Mario Draghi arrives at a European Union leaders summit in Brussels June 28, 2013.

Credit: Reuters/Francois Lenoir

FRANKFURT (Reuters) - The European Central Bank will leave interest rates unchanged on Thursday and try to reassure investors rattled by new turmoil in Europe and the U.S. Federal Reserve's plans to begin winding up its stimulus.

The ECB meets against a backdrop of political crisis in Portugal that pushed its benchmark bond yields above 8 percent - a spike that stirred angst in financial markets already jittery after the Fed last month set out a plan to exit from its money-printing program.

The tensions there, and in Greece, risk sapping confidence a year after ECB President Mario Draghi imposed some calm by vowing to do "whatever it takes" to save the currency.

"The ECB needs to reassure markets that it is not going to try to get ahead of the Fed and tighten even earlier, so it's all about guidance as far as that is possible at the ECB," said Berenberg bank economist Christian Schulz.

A Reuters poll of economists last week pointed to the ECB leaving its main refinancing rate on hold at 0.5 percent until at least the end of 2014.

An acceleration in euro zone inflation in June and stronger-than-expected consumer spending in France and Germany reinforce the ECB's projection for a slow euro zone recovery late this year, leaving it little grounds to justify a rate cut now.

But after Draghi disappointed markets at the bank's June meeting by dousing their expectations of any imminent policy action, he needs to strike a more reassuring tone this time even if the ECB keeps its powder dry.

Instability in Italy's ruling coalition and Greece's scramble to convince its lenders to dole out another tranche of aid add to the sense of turmoil ahead of the ECB meeting.

But with the ECB's bond-buying program requiring a country to seek outside help from the euro rescue fund first and be issuing debt regularly on the bond market, none of the euro zone members in trouble qualify for that help, begging the question what can the ECB do.

BALANCING ACT

Last week, Draghi said ECB policy would remain accommodative and that the bank stood ready to act again if needed. But he added that it has done "as much as it can to stabilize markets and support the economy", pressing governments to reform.

"The challenging balancing act is that he has to talk up the economy, he has to send a clear message to markets that the OMT (bond-buying) plan could still be used, giving financial markets confidence," said ING economist Carsten Brzeski.

"At the same time, he has to keep up pressure on governments to continue their reforms. He cannot promise too much, he cannot be too confident because otherwise he would again lower the pressure on governments."

Investors will listen carefully to Draghi for any clues as to whether the ECB is more open to deploying its policy options than a month ago, when he said they were on the shelf.

One of the tools the ECB is looking at is forward guidance - to reduce volatility by guiding markets where interest rates will be in future, especially once rates have reached their lowest limit.

The Fed does it and the Bank of England may soon start.

In his strongest form of guidance so far, Draghi said last week an exit from the ECB's ultra-loose policy stance "is still distant since inflation is low and unemployment high".

The Fed, frustrated by a fitful U.S. recovery, has promised to keep its main interest rate near zero at least until the unemployment rate falls to 6.5 percent and as long as inflation stays below 2.5 percent. It has now also laid out an exit plan.

Over the weekend, policymaker Benoit Coeure hinted the ECB could move, saying it was looking carefully at the Fed's experience of giving future guidance, but adding that it was too early to say if the ECB was going to take a bigger step in that direction.

Berenberg's Schulz thought the chances of a move towards Fed-style forward guidance were slim: "That would be a dramatic shift that I don't think is likely. The best case would be for the ECB to unanimously signal that there is no question of any kind of tightening," he said.

(Editing by Mike Peacock)

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