Dec. 2 (Bloomberg) -- The European Central Bank kept interest rates at a record low as investors look to President Jean-Claude Trichet for an announcement on how the bank will fight the worsening sovereign debt crisis.
ECB officials in Frankfurt set the benchmark lending rate at 1 percent for a 20th month, as predicted by all 52 economists in a Bloomberg News survey. Attention is now on Trichet’s 2:30 p.m. press conference and whether he will take more action to stop the spread of the crisis, such as extending the ECB’s provision of unlimited liquidity for banks and significantly ramping up its bond purchases, both of which were supposed to be temporary measures.
“I still don’t believe in massive bond buys, possibly that’s more wishful thinking by markets,” said Carsten Brzeski, an economist at ING Groep NV in Brussels and a former European Commission official. “The U-turn would be extreme and it’s not the task of the ECB to solve countries’ solvency problems.”
Trichet has been forced into an about-face before. On May 6, as Greece’s budget crisis was fueling investor concerns about the fiscal health of other euro-area nations, he resisted pressure to employ new measures, saying it was up to governments to lead the way. That lack of action triggered a bond-market selloff, forcing the ECB to start buying government debt just four days later and provoking a split on its Governing Council.
‘Carry The Show’
Trichet finds himself in a similar position today. Investors have been dumping Irish, Greek, Portuguese, Spanish and Belgian assets after the European Union-led rescue package for Ireland failed to convince them that policy makers have the tools required, or the resolve needed, to contain the crisis.
“The ECB really wants to focus on its core business but it’s not being allowed to,” said Nick Kounis, chief euro-region economist at ABN Amro NV in Amsterdam. “The politicians need to get their act together but until they do, the ECB is left trying to carry the show with these sort of facilities, which are no solution to the problem.”
Bonds, stocks and the euro today extended yesterday’s rally as markets interpreted a comment from Trichet as a signal policy makers may step up their response. Trichet told the European Parliament late on Nov. 30 that some investors are underestimating governments’ determination to defend financial stability in the currency bloc.
The euro rebounded above $1.31 and Spanish 10-year government bonds snapped an 11-day drop, sending the yield down to 5.20 percent today from 5.50 percent on Nov. 30. That’s still 239 basis points more than the yield on comparable German bunds.
It would be “more than reasonable” for the ECB to buy Spanish government bonds, Efe newswire quoted Spanish Industry Minister Miguel Sebastian as saying yesterday. He said purchasing debt was “within the orthodoxy” of central banks and the Bank of England and Federal Reserve are following such a policy, Efe reported from Moscow.
Increasing its bond purchases, or resorting to outright quantitative easing by failing to sterilize them, would see the ECB take more risk onto its balance sheet and open itself to the charge it’s financing profligate nations.
Such steps may be resisted by a group on the ECB’s 22-member council led by Bundesbank President Axel Weber, a leading contender to replace Trichet at the bank’s helm next year.
Weber opposed the bond program when it was announced on May 10 and has since called for it to be cancelled, saying it involves “stability risks” and there is no evidence it is working.
“The risk associated with bond purchases is that the credit risk does not disappear,” said Holger Sandte, chief European economist at WestLB Equity Markets in Dusseldorf. “If the worst comes to the worst, the ECB has all these risks on its balance sheet. It’s really a job for politicians to rescue sovereigns.”
Weber and policy makers such as ECB Executive Board member Juergen Stark are also pushing for the bank to resume its withdrawal of cheap loans to banks as the economy improves. The phasing out of the liquidity measures “will continue” after the end of the year, Stark said on Nov. 16.
The ECB publishes its latest projections today. They may show the euro area’s recovery continuing next year as Germany, the region’s largest economy, prospers from export demand and rising household spending.
Next Exit Step
The ECB currently offers banks as much cash as they need at its benchmark rate for periods of one week, one month and three months. Last month, Trichet said the ECB will announce further steps in its exit from unconventional measures in December due to concerns that banks are becoming “addicted” to the abundant liquidity.
The next likely step in the exit would be announcing a return to an auction procedure for the three-month loans, said Klaus Baader, co-chief euro-area economist at Societe Generale in London. That could limit the amount banks are able to borrow and result in a higher interest rate.
“The ECB is dead set on unwinding measures” so a discontinuation of the full allotment in its three-month refinancing operations “is still likely, although a close call,” said Baader. “They could give a clear date so the decision is taken, but not implemented immediately. That’s a compromise that would be beneficial to all.”
‘Add to Alarm’
Even a move in that direction risks further unnerving investors and exacerbating market tensions, said Ken Wattret, chief euro-area economist at BNP Paribas in London. “If the ECB really goes ahead with the exit or even just signals it will proceed with the exit, it will add to alarm.”
Morgan Stanley economists Joachim Fels and Elga Bartsch said in a research note that there’s a “good chance” the ECB will reverse its exit and reintroduce unlimited 12-month loans to banks.
Saying it will buy more government debt would also calm markets, said Holger Schmieding, chief economist at Joh Berenberg Gossler & Co. in London.
The ECB has already stepped up its activity, last week buying the most bonds in two months. Yesterday it bought Irish government bonds in bigger amounts than it typically does, according to two people with knowledge of the transactions.
Overall purchases so far total 67 billion euros ($88 billion), well below the amounts bought by the Bank of England and the Fed.
“To avoid the risk of a market panic the ECB can do more and should buy more government bonds,” said Schmieding. “If the patient is in danger of a heart attack, a medicine with side effects is justified.”
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