ECB to hold rates after Draghi's hectic first year

FRANKFURT Tue Nov 6, 2012 7:15pm GMT

1 of 2. The European Central Bank (ECB) President Mario Draghi reacts during the monthly news conference in Frankfurt, February 9, 2012.

Credit: Reuters/Alex Domanski

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FRANKFURT (Reuters) - The European Central Bank is set to leave interest rates unchanged on Thursday, deferring a cut in borrowing costs that would risk undermining the impact of Mario Draghi's signature policy a year into his ECB presidency.

A raft of weak economic data support the case for cutting rates but to do so could stir up debate in Germany about the ECB going soft under Draghi and blunt the impact of his new bond-purchase plan, dubbed Outright Monetary Transactions (OMT).

A Reuters poll last week gave an 80 percent chance the ECB will hold its main rate at 0.75 percent, though most of the 73 analysts polled expected a cut to a new record low of 0.5 percent within the next few months.

Yields on Spanish government bonds have dropped by some 2 percentage points since Draghi said in late July the ECB was ready to do "whatever it takes to preserve the euro" -- a pledge that heralded the bond-buying plan, which he formally announced in September.

The drop in yields has come without the ECB buying any bonds. For the central bank to do so, a country must first seek help from Europe's bailout fund, aid that requires approval by Germany's parliament.

"The OMT is the most powerful tool the ECB has," said Berenberg Bank's Christian Schulz, a former ECB economist. "A rate cut would probably not do very much and it could start discussions in Germany again about the ECB being too soft.

"If German political opinion swings back against the ECB, it may well be that the signal effect of the OMT is weakened because markets panic about Germany's support."

Draghi, who took over the ECB presidency from Frenchman Jean-Claude Trichet on November 1 last year, took the unusual step of visiting German lawmakers late last month to defend the OMT programme. That helped stem German criticism of the plan.

The Italian has taken the ECB into uncharted waters.

In just a year, Draghi's ECB has funnelled over 1 trillion euros into the financial system with ultra-long loans, cut its main interest rate below 1 percent for the first time and forged the OMT plan despite the opposition of Germany's Bundesbank.

The ECB held fire last month after the burst of action and will likely do so again when its policymakers meet this week, despite a drop in German business confidence and a decline in euro zone manufacturing for the 15th month running in October.

"The interest rate decision is likely to be characterised as being unanimous. I think that would reinforce expectations that there is no urgency at the Governing Council level to be cutting interest rates at this stage," said Nick Matthews at Nomura.

"Maybe next year," Matthews said, noting that the ECB's policy statement last month tied both the growth and inflation outlook in the euro zone to the sovereign debt crisis.

WAITING FOR SPAIN ... AND MERSCH

Investors and euro zone policymakers have been urging Spain to seek aid from Europe's bailout funds to allow the ECB to begin buying its bonds under the OMT.

Austria's man at the ECB, Ewald Nowotny, said on Tuesday it made sense to deploy the programme to dispel market doubts.

Spanish Prime Minister Mariano Rajoy has so far avoided seeking help, saying he wants assurances ECB intervention would bring down Spain's debt costs.

"All Draghi can really do is say 'the ECB is ready to undertake OMTs once all the prerequisites are in place'," Matthews said.

ECB policymakers have insisted it is up to Spain to decide whether to seek the aid that would allow them to intervene.

The ECB meets as international lenders prepare a report on Greece's finances, though a senior EU official said on Monday a deal on keeping Athens afloat and providing more bailout money for the near-bankrupt state is unlikely to be reached next week when euro zone finance ministers meet.

Germany and the International Monetary Fund are at odds over the need for euro zone governments and the ECB to take a "haircut" on Greek bonds they hold to make the numbers add up.

The central bank has refused to take such a hit on its Greek bonds. Another idea analysts have discussed to help bridge Greece's financing problems is for the ECB to allow Athens to issue more short-term debt, or T-bills.

Greek banks no longer have access to the wholesale market and are dependent on the national central bank for liquidity. The Bank of Greece is, in turn, dependent on ECB approval for providing this Emergency Liquidity Assistance (ELA), so greater bill issuance cannot go ahead without the ECB's consent.

In August, the ECB agreed to raise the ceiling on the amount of T-Bills the Bank of Greece can accept as collateral in exchange for emergency loans to keep the country afloat until the troika decides if it will get the next tranche of aid.

"I don't think they will close the door on that completely but I think they will make clear that was a temporary measure back in August," Berenberg's Schulz said of increasing the ELA.

Thursday's meeting is also clouded by a diplomatic spat after Spain blocked the appointment of Yves Mersch to the ECB's six-member Executive Board, the nucleus of the policymaking Governing Council.

Draghi is likely to stick closely to the line he took in testimony to the European Parliament on October 9, when he said that "especially in times of crisis, the Executive Board should be completed and (Mersch's) nomination should go through".

(Editing by Mike Peacock)

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