Draghi May Move Toward Rate Cut as Debt Crisis Worsens

The European Central Bank may edge closer to cutting interest rates to a historic low as the debt crisis tightens its grip on the euro economy and threatens to hurt global growth.

While ECB officials meeting in Frankfurt will leave the benchmark rate at 1 percent today, according to 32 of 44 economists surveyed by Bloomberg News, 11 predict a quarter-point reduction and one forecasts a half-point cut. With European governments struggling to fix a crisis that’s engulfing Spain and could force Greece out of the euro, pressure is mounting on the ECB to lower rates and introduce more liquidity support for banks.

The Group of Seven nations yesterday agreed to coordinate their response to Europe’s turmoil, which has tipped at least eight of the 17 euro-area economies into recession and damped European demand for foreign goods. ECB President Mario Draghi, who said last week the monetary union is “unsustainable” in its current form, could choose to withhold further stimulus until governments do more to tackle the causes of the crisis.

“Despite the recent escalation, the ECB seems to insist on getting backing from governments before going ahead with additional measures,” said Juergen Michels, chief euro-area economist at Citigroup Inc. in London. Still, “the current combination of moderating inflation and falling sentiment data are paving the way for lower rates soon.”

G-7 Concern

G-7 finance ministers and central bankers discussed “progress toward financial and fiscal union in Europe” on a conference call yesterday that focused on Spain and Greece, officials said.

European representatives “said they will speed up their efforts to resolve those problems, which was encouraging to us,” Japanese Finance Minister Jun Azumi told reporters in Tokyo, adding “Japan is ready to provide support if there is anything we can do.”

The Reserve Bank of Australia cited Europe’s crisis when cutting its benchmark rate yesterday by a quarter point to 3.5 percent, while the Bank of Canada held its key rate at 1 percent. The Bank of England will announce its latest policy decision tomorrow amid speculation it could increase asset purchases after the U.K. slipped back into recession.

New Projections

ECB officials, convening a day earlier than usual due to a public holiday in some German states tomorrow, will announce their rate decision at 1:45 p.m. Draghi holds a press conference 45 minutes later, at which he will unveil the central bank’s latest forecasts for the euro area.

The ECB in March predicted an economic contraction of 0.1 percent for 2012 and growth of 1.1 percent for 2013. Inflation was projected to average at 2.4 percent this year and 1.6 percent next. Economists said they expect modest downward revisions to both the inflation and growth outlooks.

The euro-area economy contracted 0.1 percent in the first quarter from a year earlier, the European Union’s statistics office said today, revising down its initial estimate from unchanged. It confirmed gross domestic product was unchanged from the fourth quarter of 2011.

“The ECB might want to wait for further corroborating data to conclude that its second-half-of-the-year recovery expectations are challenged,” said Silvio Peruzzo, an economist at Royal Bank of Scotland in London. “We push back our June rate cut to July, but we do not exclude the possibility that the ECB might pre-announce it this week, recognizing the increasing downside risk to the economy.”

Shrinking Economy

While the euro region narrowly avoided recession in the first quarter, latest data suggest the economy is shrinking again. Unemployment has reached 11 percent, the highest level on record, and purchasing manager indexes show manufacturing and service industries are contracting at a faster pace than they were when the ECB last cut rates in December.

International Monetary Fund Managing Director Christine Lagarde said in an interview with Sweden’s Svenska Dagbladet published June 4 that it’s “clear” the ECB has room for another rate cut.

Economists said Draghi is likely to announce today an extension of the ECB’s policy of full allotment in its refinancing operations, which has been the main plank of its crisis response since 2008.

The ECB has also pumped more than 1 trillion euros ($1.2 trillion) in three-year loans into the banking system, and outgoing Executive Board member Jose Manuel Gonzalez-Paramo said in an interview on May 31 that the full effect of that measure has yet to be felt.

Pressure on Governments

“We certainly expect Mario Draghi to underscore that the ECB has not run out of options yet,” said Elwin de Groot, senior market economist at Rabobank Nederland in Utrecht. “However, letting go now would remove any pressures on European policy makers to come up with a set of structural solutions to this sovereign debt crisis.”

U.S. President Barack Obama has criticized European governments for not doing enough to arrest the crisis, now in its third year. Investor concern about political inaction drove Europe’s Stoxx 600 Index down 8 percent last month, fully erasing gains this year, while the euro has plunged to a two-year low against the dollar. It traded at $1.2490 today.

Billionaire investor George Soros said on June 2 that European leaders, foremost among them German Chancellor Angela Merkel, have a three-month window in which to “correct their mistakes and reverse the current trends.”

Spain, which has resisted pressure to become the fourth euro-area nation to seek a bailout, yesterday called for the first time for European funds to shore up its banks.

Greek Elections

The spread between Spanish and German 10-year bond yields widened to a record 5.4 percentage points last week and the cost of insuring against default on Spanish sovereign debt rose to a historic high.

Greece will meanwhile hold fresh elections on June 17 that could hand more power to parties opposed to the terms of the nation’s rescue package and precipitate its exit from the monetary union.

Further economic weakness or market tension “may convince the ECB to become more accommodative this summer,” said Nikolaus Keis, an economist at UniCredit Research in Munich. “While a rate cut and the options for the provision of further liquidity will most likely be discussed, the Governing Council is unlikely to reach consensus for immediate action.”