Tags: ECB | europe | Economy | Protests

ECB’s Hands Tied as It Faces Weak Economy, Protests

Wednesday, 02 May 2012 11:03 AM

The European Central Bank will face a deteriorating economy with its key weapons muzzled when its policymakers meet Thursday in Barcelona, Spain, surrounded by heightened security against potentially violent protests.

The bank has so far used interest rate cuts, bond purchases and cheap loans to ease the 2 1/2 year-old debt crisis. But analysts say it likely can't or won't roll any of them out again soon unless things worsen significantly.

That lack of options puts more urgency into ECB president Mario Draghi's recent call for Europe to agree on a "growth compact" to find a lasting path to recovery, and more pressure on eurozone governments to fix budgets and cut burdensome regulation.

With inflation stubbornly above the bank's goal of just under 2 percent, the ECB's 23-member governing council is expected to leave its benchmark interest rate unchanged at a record low of 1 percent on Thursday.

The meeting, one of two held each year away from the bank's Frankfurt headquarters, will take place in one of the most indebted regions of Spain — the heart of the European debt crisis, where unemployment is near 25 percent and the economy is back in recession.

Spanish authorities are deploying an extra 2,000 police and have tightened border controls for the event. Spain has suspended the provisions of the Schengen treaty — which allows people to cross borders of participating countries without passport checks — to keep out violence-minded protesters.

The city saw clashes in March between police and protesters during a general strike over government cutbacks as well as demonstrations for May Day this week.

Despite the social and economic misery afflicting Spain and much of Europe, the members of the ECB's governing council will have little to offer by way of new support.

Annual inflation in the eurozone at 2.6 percent in April is falling only slowly. The ECB expects it will be 2013 before it falls below 2 percent.

Rate cuts can help growth but may also push up inflation, meaning the ECB is less unlikely to lower borrowing rates even amid worsening growth outlooks. Many analysts predict the eurozone economy will go through a deeper recession than originally expected.

Eurozone output shrank 0.3 percent in the fourth quarter and is expected to have contracted again in the first quarter. Worse, several leading indicators suggest that weakness may continue into the second half of the year and defy the ECB's prediction of a moderate recovery.

And while growth predictions darken, borrowing costs for Spain and Italy remain high, fueling doubts about their ability to avoid a financial collapse that could strain or exceed the eurozone's ability to bail them out. Greece, Portugal and Ireland have already been rescued, but the econmies of Spain and Italy are many times larger.

"While, throughout the crisis, the ECB has been the fire brigade, even the fire brigade can reach its limits," ING economist Carsten Brzeski wrote in a note to investors. "This is an uncomfortable situation for the ECB, and a reason why ECB president Draghi may try to put the ball back into the court of the eurozone politicians."

Draghi has echoed calls by French presidential candidate Francoise Hollande for a "growth compact" alongside the fiscal treaty limiting spending and debt signed by European governments in March.

Boosting economic growth would help offset the negative side-effects of austerity measures, which tend to hurt economic activity by removing government spending.

Draghi did not flesh in details on such a growth compact but will likely be asked about it at his post-decision news conference.

Two other key ECB financial tools — bond purchases and cheap loans to banks — are also unlikely to be used soon.

The ECB steadied financial markets with two massive handouts of cheap credit to banks totally just over €1 trillion ($1.3 trillion) in December and February. The ECB says that has made it easier for banks to loosen their lending standards, though businesses are not asking for the loans because they are worried about the economy.

The ECB says it is still analyzing the effects of the loans — dubbed LTROs, for longer-term refinancing operations — so analysts think another handout is unlikely to happen soon, if at all.

The bank still has its program to purchase government bonds of shaky countries in the secondary market. It could reactivate it at any time — but several top ECB board members have argued against the program. It had only a modest effect on bond markets in any case — in part because the ECB stressed it was temporary and limited — and was superseded as the chief anti-crisis weapon by the LTROs.

Its further use would be hampered by market realization that bonds held by the ECB could be favored over bonds held by private investors in case of default. That is what happened when the ECB refused to take losses on its Greek bond holdings when the country agreed on a debt writedown. Investors might demand more interest risk premium for holding government bonds in case of an ECB bond market intervention since they could be second in line for payment after the ECB in case of default.

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Wednesday, 02 May 2012 11:03 AM
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