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The European Central Bank (ECB) President Mario Draghi speaks during the monthly news conference in Frankfurt, February 9, 2012. (ALEX DOMANSKI/REUTERS)
The European Central Bank (ECB) President Mario Draghi speaks during the monthly news conference in Frankfurt, February 9, 2012. (ALEX DOMANSKI/REUTERS)

ECB sees risks to economic recovery Add to ...

The European Central Bank held interest rates at a record low of 1 per cent on Wednesday, resisting German pressure to flag an exit from its crisis-fighting mode while support measures take full effect and support an increasingly shaky recovery.

A batch of grim economic indicators and renewed concerns about the public finances in Spain - the euro zone’s fourth-largest economy - have fuelled worries that the euro zone is in recession and that the sovereign debt crisis may flare up again.

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“Downside risks to the economic outlook prevail,” ECB President Mario Draghi told a news conference after the bank held rates, as expected.

Germany’s powerful Bundesbank has led a push by central bankers from the euro zone’s core for the ECB to begin preparing an exit from crisis measures that have seen it loosen the rules for tapping ECB funding operations.

The ECB has pumped over €1-trillion into the financial system with twin three-year funding operations, or LTROs, to head off a credit crunch that late last year risked exacerbating the euro zone crisis and jeopardizing the currency project.

Asked about pressure to prepare an exit strategy, Mr. Draghi said such talk was premature, adding: “I think the president of the ECB is the one who has the last word on this.”

However, in his opening statement Mr. Draghi sought to assuage German concerns that the wall of money unleashed by the twin LTROs could stoke inflation pressures.

“All our non-standard policy measures are temporary in nature,” he said. “All the necessary tools are available to address upside risks to medium-term price stability in a firm and timely manner.”

The German-led group of policymakers is concerned that the LTROs risk stoking inflation pressures.

Euro zone inflation eased to 2.6 per cent in March - above the ECB target of just below 2 per cent and higher than expected - but the renewed worries about Spain mean the ECB cannot afford to signal a rate rise or an exit from the funding measures.

“I don’t think I’m stepping up my rhetoric on inflation,” Mr. Draghi said.

Spanish borrowing costs jumped at bond auctions on Wednesday, spreading fear in wider European markets and overshadowing a successful step back into debt markets by neighbouring Portugal.

A rise in government bond buys by banks in Spain and Italy in February showed they were plying the “Sarkozy trade” - a term adopted by markets after the French president suggested governments urge banks flush with ECB cash to buy their bonds.

This trade helped push down yields on Spanish and Italian government bonds, but the renewed concerns about the public finances in Spain - the euro zone’s fourth-largest economy - have sent them higher again.

Madrid is battling to convince European partners and debt markets it can rein in its budget deficit in the face of growing complaints from the public.

The ECB believes it has done as much as it can to fight the crisis and Draghi has put the onus firmly on governments to act.

Mr. Draghi said the rise in yields showed markets expected governments on the euro zone periphery to deliver reforms.

“Markets are asking these governments to deliver,” he said.

He played down concerns that the ECB’s funding operations have made banks too dependent on its loans, saying: “We don’t see any sign that banks are being addicted to the ECB.”

While Mr. Draghi said last month the worst of the crisis was over, the latest economic data show the economy stumbling again.

Sagging orders kept euro zone businesses in the doldrums in March, probably pushing the region into a mild recession although companies became more confident that better times lie ahead, a survey showed earlier on Wednesday.

The slump means that even though inflation has proved to be stickier than forecast, the ECB is not about to tighten policy any time soon. It had to reverse two rate rises last year as the crisis came back with a vengeance and will be careful not to repeat the mistake of abandoning its low-rate policy too soon.

Analysts have pushed back their view on the next rate move, a Reuters poll showed. They now expect rates to have reached a floor - they equal a record low 1.0 per cent - and tip them to go up late next year at the earliest.

Some economists even believe that, despite pressure from the hardliners to prepare an exit strategy, the ECB will need to cut rates again later this year.

“With more negative news on the economy coming through and probably also inflation to decline further, we still think there is room for lower rates over the course of the year,” said Juergen Michels at Citigroup, who expected two more 1/4-point rate cuts this year to take the headline rate to 0.5 per cent.

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