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ECB Keeps Interest Rates on Hold as Draghi Gets Reprieve

ECB Headquarters Stand in Frankfurt
The stars of European Union (EU) membership sit on a euro sign sculpture outside the headquarters of the European Central Bank (ECB) in Frankfurt. Photographer: Ralph Orlowski/Bloomberg

The European Central Bank kept interest rates unchanged as stronger inflation and economic output reduced the need for officials to take action.

The Governing Council left the main refinancing rate at a record low of 0.25 percent at its meeting in Frankfurt today. The decision was forecast by 40 out of 54 economists in a Bloomberg News survey. The rest forecast a cut. The deposit rate was kept at zero and the marginal lending rate at 0.75 percent.

A month after saying he needed more information on the economy before deciding whether to act against the threat of deflation, ECB President Mario Draghi has been handed a better-than-forecast report card on the 18-nation euro area’s economy. While measures to rekindle lending and help banks are still on the table, including the release of cash linked to crisis-era bond purchases, Draghi’s main scenario is to let the recovery erode idle productive capacity and boost prices.

“The euro zone is on track to slowly chip away at the slack in the economy, with confidence pointing to gradually rising growth rates and unemployment stabilizing,” said Christian Schulz, senior European economist at Berenberg Bank in London. Even so, inflation “remains far below the ECB’s price-stability target,” he said.

Draghi will hold a press conference at 2:30 p.m. in Frankfurt to explain the decision. The Bank of England kept its benchmark rate at a record-low 0.5 percent at 12 p.m. in London, while its bond-purchase plan remained at 375 billion pounds ($627 billion).

Fresh Projections

The ECB’s updated projections for euro-area growth and inflation will be released today, including forecasts for 2016 that extend the central bank’s outlook to three years for the first time.

When Draghi said last month that policy makers “need to acquire more information” to analyze the “complexity of the situation” in the euro-area economy, his watch list included four bullet points: growth data from the end of last year, the impact of turbulence in emerging markets, credit supply to companies and households, and new economic forecasts prepared by the ECB’s staff.

While the recovery remains fragile, data in the past four weeks have been encouraging. Gross domestic product in the bloc grew 0.3 percent in the fourth quarter, more than economists predicted, bolstered by stronger expansions in Germany, France and the Netherlands and a return to growth in Italy. Economic sentiment rose to the highest level in more than 2 1/2 years in February, and services and manufacturing expanded the most since June 2011.

Inflation Outlook

“Activity numbers are actually picking up quite decently and the ECB is likely to revise up its GDP forecast at least for this year,” said Anders Svendsen, an economist at Nordea Bank Denmark A/S in Copenhagen. “Yes, inflation is low and will remain low for a long time, but this is not new to the ECB, and inflation is probably very close to bottoming out.”

The ECB predicted in December that the 18-nation economy would expand 1.1 percent this year and 1.5 percent in 2015. It said inflation will average 1.1 percent and 1.3 percent, respectively, below the 2 percent level the ECB defines as price stability.

Inflation has accelerated since reaching a four-year low of 0.7 percent in October. Annual consumer-price gains held at 0.8 percent in the first two months of this year, exceeding economists’ forecasts. Stripped of volatile components such as energy and food, core inflation was 1 percent last month, the highest level since September.

Deflation Risk

ECB officials will debate how likely that improvement is to be sustained. Governing Council member Ewald Nowotny has said that inflation may “self-correct” as the economy improves, while Executive Board member Benoit Coeure has expressed more concern. The euro region is “closer to the area where inflation expectations could be altered and create downside risks to price stability,” he said in an interview with Slovenian newspaper Delo published on the ECB website on Feb. 15.

Inflation expectations as measured by 5-year/5-year forward breakeven rates in Germany, the region’s largest economy, dropped to the lowest in 11 months in February. Morgan Stanley, which predicted the ECB’s benchmark rate would be cut to 0.1 percent today, estimates there is a 35 percent risk the euro area slides into deflation. Societe Generale SA, which forecast no change in rates, puts the probability at 15 percent.

Liquidity Measures

Those perceived risks may mean policy makers feel they need to act in other ways, even as the data support the case for keeping policy unchanged.

“Most ECB Governing Council members have tried to keep all options open for the March meeting,” said Michael Schubert, an economist at Commerzbank AG in Frankfurt and the only forecaster to predict a cut in the deposit rate.

Halting the absorption of liquidity created by bond purchases under the ECB’s now-defunct Securities Markets Program may be a “compromise” solution, even though it will “help little in addressing alleged disinflation risks,” he said.

Pausing the weekly operations would add about 175 billion euros ($240 billion) of liquidity to the financial system. It would also pose a challenge to the ECB’s credibility. Former ECB President Jean-Claude Trichet made sterilization part of the SMP program in 2010 to allay concerns that the bond-buying would stoke inflation.

Credibility Risk

“Credibility is critical, but never more so than in an environment when the central bank is using forward guidance on interest rates and liquidity provision to stabilize the situation,” said Richard Barwell, senior European economist at Royal Bank of Scotland Plc in London. “It is unwise for the council to go back on commitments it made in the past without an exceptionally good reason.”

Trichet said this week that pausing the operation is “certainly possible.” Germany’s Bundesbank, whose presidents have opposed government-bond purchases and repeatedly warned of the risks they entail, said on Feb. 17 that it would support such a move.

Other ways to ease funding conditions include lowering reserve requirements, offering more long-term loans or bolstering the market for asset-backed securities, either by purchasing the securities outright or encouraging their use as collateral in refinancing operations.

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