The European Central Bank has to decide how big a threat Italy poses to Europe’s recovery.
A rejection of austerity in the euro area’s third-largest economy has produced a political stalemate that’s driven up bond yields and undermined confidence in ECB President Mario Draghi’s scenario of a gradual economic upturn. While that’s prompted some observers to bring forward expectations for lower interest rates, economists from Nomura International Plc to ABN Amro Bank NV say the ECB is more likely to hold fire and keep the pressure on governments to enact reforms.
“The Italian election has brought the centrifugal force of dysfunctional politics back into focus, but rate cuts are not the answer,” said Richard Barwell, senior economist at Royal Bank of Scotland Group Plc in London. “The ECB cannot save governments and countries that do not want to save themselves.”
Italy is threatening to unravel the relative calm that Draghi’s pledge to safeguard the euro brought to markets last year. With the 17-nation currency bloc struggling to exit recession, the ECB could be forced to lower its economic forecasts today. At the same time, the euro’s recent decline might ease concern that inflation will drop too far below the central bank’s 2 percent target.
Policy options available to the ECB include rate cuts, more long-term loans to banks, and measures to encourage bank lending to small and medium-sized companies that are struggling to gain access to credit, economists said.
The ECB will keep its benchmark interest rate unchanged at a record low of 0.75 percent today, according to 56 of 61 economists surveyed by Bloomberg News. Five predict a reduction to 0.5 percent. The ECB announces its decision at 1:45 p.m. in Frankfurt and Draghi holds a press conference 45 minutes later.
The Bank of England will hold its bond-purchase program at 375 billion pounds ($565 billion) and keep its key rate at 0.5 percent, separate surveys show. That decision is due at noon in London. The Bank of Canada yesterday kept its benchmark rate at 1 percent and softened language about tighter policy for the second meeting in a row.
The Bank of Japan also left policy unchanged and rejected a call for an immediate start to open-ended asset purchases in Governor Masaaki Shirakawa’s final meeting before a new leadership takes over.
Draghi will be probed on Italy, where bond yields surged after anti-austerity parties led by former Prime Minister Silvio Berlusconi and comedian Beppe Grillo won about 55 percent of the vote in last month’s election.
Relative yields on bonds sold by Italian, Greek, Spanish, Portuguese and Irish companies jumped to 220 basis points on March 4, the widest since Dec. 13, according to Bank of America Merrill Lynch’s Euro Non-Financial Periphery Index. The spread was 216 basis points on March 5. The difference between their funding costs and those of firms in the region’s core nations including Germany and France is holding near the widest since Nov. 28, Bank of America index data show.
That’s raised questions about whether the ECB would step into the breach if market turmoil escalated, threatening the economic recovery. The ECB’s as-yet-untapped bond-purchase program, known as Outright Monetary Transactions, can only be activated if a country requests aid from Europe’s rescue fund and agrees to reforms.
‘Send a Warning’
“I expect the ECB to send a warning in Italy’s direction that there won’t be any softening of the conditions attached to the OMT,” said Christian Schulz, senior economist at Berenberg Bank in London. “Draghi will reiterate the conditions agreed upon in September and imply that Italy shouldn’t turn to the ECB for help.”
Still, increased uncertainty is beginning to show in the survey indicators on which Draghi has built his expectations for a gradual recovery in the second half of the year. Investor confidence declined this month for the first time since August, and a gauge of manufacturing and services output worsened.
The ECB will probably revise down its growth and inflation forecasts to reflect a worse-than-predicted economic contraction in the final quarter of 2012 and the euro’s appreciation at the beginning of this year, said Anders Svendsen, an economist at Nordea Bank AB in Copenhagen.
The ECB’s staff currently predicts the economy will contract 0.3 percent this year before growing 1.2 percent in 2014. Inflation is seen averaging 1.6 percent this year and 1.4 percent next year.
“The staff projections are weak enough to justify a refi-rate cut if the ECB wants to cut, but the ECB probably believes that the benefits will be too small,” Svendsen said. “We expect no outright signals of more rate cuts at this point.”
ECB council member Christian Noyer said last month there is “no particular interest in cutting rates by a few cents if it only impacts Germany or core countries.”
Germany, Europe’s largest economy, is powering ahead. Business confidence jumped to a 10-month high in February and factory orders and industrial production are picking up.
“A lot points to a recovery later this year,” said Schulz. “If anything, I expect the ECB to discuss a rate increase rather than a rate cut toward the end of the year.”
Economists surveyed by Bloomberg predict the benchmark rate will stay unchanged through the second quarter of next year as officials remain preoccupied with fixing the transmission channel of monetary policy.
Draghi told lawmakers in Brussels last month that “the number-one challenge” at the moment is to ensure that ultra-low interest rates are feeding through to the economy.
Banks have started to repay the ECB’s three-year loans, or Longer Term Refinancing Operations, which were designed to prevent a credit squeeze and encourage lending. That’s pushed up borrowing costs in financial markets and sparked concern about a premature tightening of monetary conditions.
The rate on three-month Euribor futures expiring in December rose to 0.575 percent on Jan. 28, the highest since the beginning of July. It fell to 0.255 percent yesterday.
“The president might hint that the ECB could provide even more funding to those in need through extra long-term LTROs in future,” said Jennifer McKeown, senior European economist at Capital Economics in London. “He might also say more about ways for the bank to circumvent the persistent weakness of bank lending and get funds to firms and households directly.”
At the same time, concern about the side-effects of expansionary policy is growing at the ECB. Executive Board members Peter Praet and Yves Mersch last week warned of the risks in leaving emergency stimulus in place for too long.
“If we look at recent comments from the board, they say there are signs of stabilization, green shoots, they speak about a nascent recovery,” said Nick Matthews, senior euro-area economist at Nomura in London. “It doesn’t sound like someone is asking for a rate cut. In the short-term, I don’t see why Italy makes it more likely.”