Under Draghi, ECB on verge of major policy shift

AP News
Posted: Dec 06, 2011 1:31 PM
Under Draghi, ECB on verge of major policy shift

The European Central Bank stands on the verge of a major policy shift to try and save the euro under the leadership of its new president, Mario Draghi, in office just over a month.

As Europe's debt crisis worsened over the past two years, the ECB's crisis response had increasingly been deemed too timid by economists. That appears to be ready to change _ if Draghi's intentions have been read correctly.

In recent days, the bank has voiced and shown a greater willingness to get active. The shift, analysts say, is both a sign of Europe's rapidly deteriorating economic and financial condition, and of Draghi's pragmatism relative to his predecessor, Jean-Claude Trichet.

The ECB will likely give European banks a boost this week by making longer-term emergency loans available and reducing interest rates for the second month in a row. Many think it is on the cusp, however, of a much larger step aimed at preventing a global financial crisis _ large-scale purchases of European government bonds.

Draghi hinted in a speech to the European Parliament last week that a precondition for any further ECB bond purchases would be a commitment by euro countries to crack down on overspending. But the fact that he made the offer at all was seen as a turning point _ a nudge to EU leaders, who will wrestle with that very topic at a summit in Brussels later this week.

The ECB's main job is to maintain price stability and preserve the purchasing power of the euro. It does this through its control of a key short-term interest rate. It can cut rates to stimulate growth, but only if inflation is deemed control.

With Europe's economy seemingly headed for a recession, some economists say the ECB should be more worried these days about the threat of inflation.

Rising expectations for large-scale bond purchases come as the bank's top leadership undergoes significant turnover.

Draghi, a former Bank of Italy head, World Bank official and Goldman Sachs vice chairman, took over Nov. 1. He brought a reputation for pragmatism when he replaced Trichet, regarded by some as an overly rigid interpreter of the bank's legal mandate to fight inflation.

Under Trichet, the ECB raised interest rates in April and July, even as the eurozone headed for deeper trouble.

The ECB's main decision-making body is a 23-member governing council, chaired by Draghi. It is made up of the top central banker from each of the 17 countries that uses the euro, plus a six-member executive committee that manages the bank's business at its Frankfurt headquarters.

Two members of the ECB's executive board will be leaving at the end of the year: Juergen Stark, a former Bundesbank official known for his tough anti-inflation stance, and Lorenzo Bini Smaghi, who resigned to make way for a French candidate for political reasons.

Their replacements will be Joerg Asmussen, German deputy finance minister, and Benoit Coeure, chief economist at the French treasury. Asmussen has been deeply involved in working out the bailouts of Greece, Ireland and Portugal.

"The diehard (inflation) hawks are gone," said economist Carsten Brzeski at ING in Brussels. "They have been replaced by more pragmatic persons, so it is a shift toward a new ECB."

Circumstances have also changed dramatically since Draghi took over. The prospect of a government-bond default by either Italy or Spain, Europe's third- and fourth-largest economies, rose sharply in recent weeks.

The yield, or interest rate, on 10-year Italian bonds has risen from under 4 percent in October, 2010 to over 7 percent as late as last week. That's the level at which Greece, Ireland and Portugal had to seek bailouts. The yields on Italian bonds fell after Draghi's remarks and budget cutbacks announced by the Italian government.

Still, Draghi will want to see more than vague expressions of good intentions by EU leaders in Brussels, says Marco Valli, chief eurozone economist at Unicredit.

Even more than the fear of inflation, the main factor holding back stepped-up bond purchases by the ECB is worry that once it acts in a big way, the pressure on governments to enforce budgetary discipline would fade away.

"The ECB's only bargaining tool at this stage is to keep as much pressure on governments," wrote economists at the Royal Bank of Scotland.

The ECB has several options to intervene more forcefully in bond markets. It could:

_ Explicitly tell markets that it won't permit Italian and Spanish bond yields to rise above, say, 5 percent. The central bank would then buy bonds until the yields fall to that level.

_ Ramp up its purchases without an announcement and let the markets take notice.

_ Issue a more vague statement that it stands ready to support governments.

_ Work alone, or with other central banks, to loan money to the International Monetary Fund, which could then help expand the size of Europe's bailout fund.

Draghi has said Europe risks "a mild recession." To stimulate growth, the ECB is expected Thursday to cut its benchmark interest rate, now at 1.25 percent, by at least a quarter percentage point. A cut would make it cheaper for companies and people to borrow and spend. The ECB could also offer more and easier credit to struggling banks.

Since Europe's debt crisis erupted in 2008, the ECB has let banks borrow any amount they want for set periods. Without that credit, economists say, banks in some of Europe's indebted countries such as Greece and Ireland would have collapsed. Or they would have restricted their own lending to businesses and consumers so much as to stifle economic growth.

The bank has made limited purchases of government bonds, about euro207 billion worth. That has helped keep borrowing costs for countries like Italy and Spain from going higher.

Hopes are rising for Friday's EU summit. On Monday, German Chancellor Angela Merkel and French President Nicolas Sarkozy proposed changes to the EU treaty aimed at tightening economic ties among the 17 countries that use the euro, better enforcing penalties for those whose budget deficits run too high.

An agreement by all 27 EU countries, or just those that use the euro, would mark a huge shift in European politics and a step forward in addressing the 2-year-old debt crisis.

Optimists hope that a deal would soothe bond investors enough to make them more willing to buy European government debt. That would give political leaders time to work on making their economies more competitive.

The question is, when might Draghi and the other 22 ECB governing council members think euro governments have done enough.

As is customary, Draghi will hold a press conference after the ECB's policy statement is released Thursday. His every word will be scrutinized and parsed by financial markets attempting to divine what further steps the ECB may be ready to take.

"We haven't learned enough about Draghi. But his first couple of public appearances as president, I think, have pointed at least toward an easing of their attitude on inflation," said Dermot O'Leary, chief economist at Goodbody Stockbrokers in Dublin.

An Italian default could shatter the finances of banks that hold its bonds and choke off their lending, as happened after the 2008 bankruptcy of U.S. investment bank Lehman Brothers. A disaster on that scale could threaten the continued existence of the euro.

Yet even a broad agreement to reduce debt and to have the ECB intervene aggressively wouldn't fix deeper problems in the eurozone: anemic growth and high unemployment in some countries and long-term trade deficits. Changes to the EU treaty could take more than a year.

ECB watchers cautioned that a small group of influential inflation hawks still on the ECB board could further complicate Draghi's job.

The top person on that list is the head of Germany's Bundesbank, Jens Weidmann, who has not been shy about voicing his opposition to bond purchases. If nothing else, such comments serve to undermine Draghi's effort to convince bond markets that the bank's approach is unequivocal.

"When it comes to this issue of bond purchases, one voice, and it's Weidmann's voice, can make a difference," Brzeski said.