Draghi Lays Groundwork for ECB Exit on Inflation

Mario Draghi
Mario Draghi, president of the ECB during a news conference in Frankfurt, on March 8, 2012. Photograph by Hannelore Foerster/Bloomberg

European Central Bank President Mario Draghi signaled he’s done enough to battle the sovereign debt crisis, laying the groundwork for an eventual exit from record-low interest rates and emergency lending measures.

Declaring that the environment “has improved enormously” and there are “many signs of returning confidence in the euro,” Draghi yesterday turned the spotlight on “upside risks” to inflation, which is now forecast to remain above the ECB’s 2 percent limit this year. That suggests policy makers don’t plan to cut rates further or add to their 1 trillion euros ($1.32 trillion) of long-term loans to banks, economists said.

“The ECB adopted a significantly less dovish tone, dropping anything that could hint at any additional non-standard measure or a further rate cut to come,” said Holger Schmieding, chief economist at Berenberg Bank in London. “Instead, the tone suggests that the ECB expects its eventual next move to be a reversal of some non-standard measures or even a rate hike.”

The ECB’s unprecedented crisis-fighting measures have swelled its balance sheet to more than 3 trillion euros, prompting Bundesbank President Jens Weidmann to write a letter to Draghi warning that the central bank may be taking on too much risk. While the ECB has repeatedly been forced to retreat from exit plans as the debt crisis spread, Draghi indicated he may share Weidmann’s desire for a return to more conventional policy settings.

The Frankfurt-based ECB must “go back to normal, classical central bank policy,” he said.

‘Primary Remit’

The euro rose after Draghi’s press conference and yields on Italian and Spanish bonds dropped. The single currency fell 1 percent today to $1.3130 at 4 p.m. in Frankfurt.

The ECB left its benchmark rate at 1 percent yesterday and issued new forecasts showing inflation will average 2.4 percent this year rather than the 2 percent projected in December. Policy makers didn’t discuss cutting interest rates, Draghi said. “What we have to have our eyes squarely on is our primary remit -- price stability in the medium term,” he said.

“The new anti-inflation rhetoric is probably rather lip service to soothe the Bundesbank than a serious intention to hike rates anytime soon,” said Carsten Brzeski, senior economist at ING Group in Brussels. However, “further rate cuts seem to be off the table.”

Oil Prices

The ECB is confronted with an oil-price increase that’s propping up inflation at a time when at least six of the 17 euro nations are in recession. The region’s economy will contract 0.1 percent this year, the ECB’s projections show, down from the previous forecast for 0.3 percent growth.

While the outlook “is still subject to downside risks,” latest data “confirm signs of a stabilization in the euro-area economy,” Draghi said, adding the ECB expects a gradual recovery in the course of this year.

Growth will accelerate to 1.1 percent in 2013 and inflation will slow to 1.6 percent, according to the ECB’s forecasts.

Greece today pushed through the biggest sovereign restructuring in history, cajoling private investors to forgive more than 100 billion euros of debt.

Euro-region finance ministers subsequently agreed Greece has met the conditions for a second rescue package worth 130 billion euros that’s designed to prevent a collapse of the Greek economy and contain the debt crisis.

If the crisis flares again or the euro-area economy is weaker than expected, the ECB would be pressed back into action, said Marchel Alexandrovich, an economist at Jefferies International in London.

‘Addicted’ to Stimulus

“Clearly the ECB does not want to get the markets addicted to the stimulus measures, but if growth disappoints and the forecasts are revised lower still, interest rates will be cut below 1 percent,” he said. “It is wrong to think that Draghi will now simply sit back and hope that the ECB’s injections of liquidity will do the trick.”

Draghi said the ECB’s two tranches of three-year loans to banks, which have helped fuel a bond-market rally, have had “a powerful effect” and been an “unquestionable success” in terms of unlocking credit markets.

“We have to see exactly how the economic and financial landscape has changed following these two operations,” he said, adding that it’s now up to governments and banks “to continue their reforms, to repair their balance sheets” so that they can “support the recovery.”

“Draghi stressed very clearly that ECB liquidity alone cannot solve the crisis, and now it is up to governments to build on this improved market mood by adopting the needed structural reforms,” said Marco Valli, chief euro-area economist at UniCredit Bank AG in Milan. “In other words, the ECB has done enough to support the recovery, and the ball is now back in politicians’ court.”

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