ECB Keeps Rate at 1% as Economy Shrinks, Price Risks Grow

April 4 (Bloomberg) -- Bloomberg's Scarlet Fu reports that the European Central Bank left interest rates unchanged as policy makers balance the threat of inflation in Germany against the need to fight the sovereign debt crisis. She speaks on Bloomberg Television's "Inside Track." (Source: Bloomberg)

The European Central Bank left interest rates unchanged as policy makers balance the threat of inflation in Germany against the need to fight the sovereign debt crisis.

ECB officials meeting in Frankfurt today kept the benchmark rate at a record low of 1 percent, as predicted by all 57 economists in a Bloomberg News survey. President Mario Draghi holds a press conference at a 2:30 p.m.

While nations from Greece to Spain are battling recessions and record unemployment, workers in Germany are winning some of the biggest pay increases in 20 years, widening the gaps between Europe’s largest economy and its euro-area peers. Draghi warned in March of “upside risks” to inflation and started talking about how to withdraw the ECB’s emergency measures, just months after cutting rates and pumping more than 1 trillion euros ($1.3 trillion) of cheap cash into Europe’s banking system to stem the sovereign debt crisis.

“Early signs of wage inflation and rising house prices in Germany will make some hawkish Governing Council members nervous,” said Christian Schulz, senior economist at Berenberg Bank in London. Still, it’s too early to start removing support for banks and “the overall weak economy easily warrants continued low interest rates,” he said.

Recessions

The 17-nation euro economy will shrink 0.3 percent this year, according to the European Commission, which projects contractions in Italy, Spain, Belgium, Greece, Cyprus, the Netherlands, Portugal and Slovenia. By contrast, Germany’s economy is forecast to expand 0.6 percent.

“The ECB is in a dilemma,” said Holger Sandte, chief economist at WestLB Mellon Asset Management in Dusseldorf. “It’s not an optimal currency area. The economy is terrible in some parts and okay in others, and prices are diverging.”

House prices in Spain plunged 11.2 percent last year; in Germany they rose 5.5 percent, the most since the country’s post-reunification property boom in the early 1990s.

Bundesbank President Jens Weidmann was one of the first ECB policy makers to start talking about an eventual exit from stimulus measures, saying the emergency lending to banks entails significant risks.

‘Stability Culture’

Draghi, in an interview with Germany’s mass tabloid Bild newspaper last month, said he shares Weidmann’s concerns and “all members of the Governing Council have taken to heart Germany’s stability culture.”

Tools the ECB could use to absorb liquidity include longer- term deposits or the issuance of debt certificates, Christian Thimann, Draghi’s adviser, said in an article published last week.

“Exit talks are in large part targeted at Germans and other inflation hawks concerned about rising inflation and the emergence of asset-price bubbles,” said Marco Valli, chief euro-area economist at UniCredit Global Research in Milan. “They want to show they have the tools available to tackle inflation, but they’re nowhere close to a starting the exit.”

While Draghi will probably affirm his view that the euro- area economy has stabilized, contracting manufacturing output suggests the recovery remains fragile.

At the same time, euro-area inflation, driven by higher oil prices and tax increases, will breach the ECB’s 2 percent limit for a second straight year in 2012 before slowing to 1.6 percent in 2013, according to ECB forecasts.

Price Pressure

Wage settlements in Germany may fuel price pressures.

With unemployment at a two-decade low and exports to countries outside the euro area partially shielding the economy from the debt crisis, German workers are asking for a bigger slice of the pie.

IG Metall, Europe’s biggest labor union with about 3.6 million workers, is demanding 6.5 percent more pay.

Germany’s 2 million public service workers are set for a 6.3 percent raise over two years under an agreement reached with the government, the Ver.di union said on March 31. That would be the biggest increase negotiated by the union since 1992.

“The agreement will likely mark a turning point in wage developments in Germany after years of wage restraint,” said Klaus Baader, an economist at Societe Generale SA in Hong Kong.

Some economists say rising German wages are part of a rebalancing that has to take place within the euro zone. Germany, which has long relied on exports for growth, needs to spur household spending, while peripheral nations have to cut wages to improve competitiveness and export performance.

“Draghi’s main message today will probably be that the ECB has done its bit,” said Julian Callow, chief European economist at Barclays in London. “One reason is that the ECB doesn’t really have another big rabbit to pull out of its hat, the other is that they really want to sit back and let governments get on with fixing the crisis.”

To contact the reporter on this story: Jana Randow in Frankfurt at jrandow@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net

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