ECB leaves benchmark interest rate unchanged

[September 06, 2012]  FRANKFURT, Germany (AP) -- The European Central Bank has left its benchmark interest rate unchanged at a record low 0.75 percent, holding off on further stimulus for the slowing eurozone economy.

Markets and analysts are focused instead on bank President Mario Draghi's news conference later Thursday, where he is expected to give further details about the bank's efforts to lower borrowing costs for heavily indebted governments.

Some economists had expected the bank to also cut interest rates in an effort to stimulate the slowing economy of the group of 17 countries that use the euro, which shrank 0.2 percent in the second quarter. The Organization for Economic Cooperation and Development, which groups the world's rich countries, warned in its interim report Thursday that Europe is entering a recession that is hurting trade and jobs elsewhere in the world.

But interest rates are already very low, and some economists question how much additional help a rate cut would provide. The bank last cut rates a quarter-point July 5.

Richard Barwell, an economist at Royal Bank of Scotland, said a rate cut might have made the ECB appear as though it "had run out of ammunition and was reduced to gesture politics."

Markets across Europe remained firm ahead of the ECB news conference. In London, the FTSE 100 index of leading shares was up 0.52 percent at 5,687, while the German DAX was up 1.2 percent to 7,047. The euro rose 0.34 percent against the dollar to trade at $1.2637.

Rates aside, the bond purchase plan, first sketched out at the Aug. 2 ECB meeting, has dominated market discussion over the last month and helped ease turmoil in the bond markets.

The bank has said it is willing to buy the short-term government bonds of financially struggling countries such as Spain and Italy. That would lower their borrowing costs. But the ECB expects them to first ask for help from the eurozone bailout fund.

Markets want to know other key details, such as how big the purchases could be, what kind of conditions would come attached to the help.

There is also concern that purchases might not have a big enough impact. An earlier euro210 billion ($264.14 billion) program, ended this year, did not decisively lower borrowing costs. Analysts say the bank may choose to keep markets guessing about the exact amount of bonds they are willing to buy; Draghi has said only that any intervention will be big enough to be effective.

Another key issue is how the bank will deal with a potentially controversial side effect of the purchases. Since the bank uses newly created money to pay for the bonds, the purchases will result in an increase in the amount of money flowing around the economy.

The bank may choose to withdraw an equivalent amount of money from the financial system by taking deposits, a tool known as "sterilization." That would blunt any criticism that the bank is using its monetary powers to finance governments, something the European Union treaty that set up the euro forbids it from doing.

The bond purchase plans have faced criticism from Germany's national central bank, the Bundesbank. Its head, Jens Weidmann, says they are too close to simply bailing out government finances. He says governments will grow addicted to the help and not reform their finances.

Draghi, backed by a majority of the 23-member governing council, argues that the bond purchases will simply lower borrowing costs that are out of line with the ECB's current low interest rate policies. The ECB's refinancing rate, which helps determine short-term rates throughout the economy, is at a record low. Yet Spain and Italy are paying painfully high rates to borrow. Spain's 10-year bonds yield over 6 percent in open market trading and Italian bonds are over 5 percent. Those yields reflect the costs governments will pay when they sell bonds, as they have to do constantly to pay off old bonds that are coming due.

The bond purchase program would drive up bond prices and bring down yields, since price and yield move in opposite directions.

[Associated Press]

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