Draghi Picks Rates Over Printing Press as Crisis Drags EU Toward Recession

By Matthew Brockett and Gabi Thesing - Nov 4, 2011 7:00 AM GMT+0700

European Central Bank President Mario Draghi signaled he’d rather use interest rates than the printing press to bolster growth as the debt crisis drags the euro-area economy toward recession.

Chairing his first policy meeting after succeeding Jean- Claude Trichet on Nov. 1, Draghi unexpectedly cut the benchmark rate yesterday by a quarter point to 1.25 percent and left the door open to a further move. At the same time, he ruled out ramping up ECB bond buying to reduce governments’ borrowing costs, saying the program is “temporary” and “limited.”

“It’s back to basics on the crisis fighting; rates rather than bond purchases,” said Julian Callow, chief European economist at Barclays Capital in London. “He must be the first ECB President to utter the word ‘recession’ before it has actually happened.”

As bond yields soared in Italy and Spain after euro-area leaders raised the prospect of Greece leaving the 17-nation currency bloc, Draghi said the debt crisis is damping growth and a “mild recession” is on the cards. The central bank will lower rates again as soon as next month to fully reverse the two increases carried out under Trichet earlier this year, economists said.

Like Bernanke

Draghi sounded more like Federal Reserve Chairman Ben S. Bernanke than Trichet, said Trevor Greetham, Director of Asset Allocation at Fidelity Worldwide Investment in London. “He put much more emphasis on growth. This suggests another rate cut in a month’s time.”

The euro fell after the ECB rate cut before recovering to trade little changed at $1.3822 at 6:30 p.m. in Frankfurt last night. Italian bond yields declined after setting euro-era records earlier yesterday.

Draghi was under pressure to step up the ECB’s bond purchases to stop the two-year-old debt crisis spreading to Italy, the region’s third-largest economy.

Irish Finance Minister Michael Noonan called on the ECB to use a “wall of money” to halt speculation and contagion after Greece’s decision to hold a referendum on its second bailout fueled concerns it may default on its debts.

Germany and France raised the stakes, saying they would interpret it as a vote on Greece’s euro membership, prompting Greek Prime Minister George Papandreou to backtrack on the plan.

‘Greek Shenanigans’

“Despite the Greek shenanigans about a referendum, the market situation is not worrying enough for the ECB to pull out the ultimate stops,” said Christian Schulz, senior economist at Joh. Berenberg Gossler & Co. in London. “The ECB is still far away from forcefully intervening to protect illiquid but solvent sovereigns.”

Draghi’s 23-member Governing Council is already split over the ECB’s bond purchases, which now amount to 173.5 billion euros ($239.4 billion).

The ECB says the purchases are aimed at ensuring its interest rates are transmitted in financial markets. German policy makers say they also reduce borrowing costs for profligate governments, blurring the line between monetary and fiscal policy.

Bundesbank President Jens Weidmann opposes the program and ECB Executive Board member Juergen Stark will step down at the end of the year over the issue.

Such a Bad Thing?

“I struggle to see how in the current environment, with inflation starting to decline in the coming months and with activity clearly weakening, asset purchases would be such a bad thing,” said Jens Larsen, London-based chief European economist at RBC Capital Markets and a former Bank of England official. “But bond purchases on a large scale seem to have basically been ruled out of the toolbox, at least for now.”

While Draghi said sluggish growth is likely to damp inflation pressure next year, Jennifer McKeown, an economist at Capital Economics Ltd. in London, said lingering concerns about price stability may be one reason why the ECB doesn’t engage in full-blown quantitative easing like the Fed and the Bank of England.

Keeping inflation just below 2 percent is the ECB’s primary mandate. It is currently running at 3 percent.

“A big move into QE may mean inflation rises in future,” said McKeown. The ECB is also “very reluctant to step in to what it considers to be the role of the region’s governments,” she said. “It’s a role for fiscal policy, not monetary policy.”

‘Get Your Act Together’

Draghi, 64, ruled out the ECB becoming “the lender of last resort for governments” and said the responsibility for financial stability rests squarely with politicians.

“Draghi made it clear that sovereign governments must not count on external help,” said Axel Merk, chief investment officer at Merk Investments LLC in Paolo Alto, California. “It’s really very simple: get your act together, national governments, and you’ll be fine. If not, you’ll pay the price.”

Group of 20 leaders meeting in Cannes, France, yesterday discussed a bigger role for the International Monetary Fund in the European debt crisis, with the U.K. joining Brazil and Russia in support of boosting the lender’s war chest.

The Organization for Economic Cooperation and Development on Oct. 31 forecast euro-area growth will slow to just 0.3 percent next year while U.S. expansion accelerates to 1.8 percent.

Of 55 economists in a Bloomberg News survey, 49 predicted Draghi would keep rates on hold at his first policy meeting to emphasize his inflation-fighting credentials. He proved them wrong.

“Central bankers tend to do what needs to be done,” said Jacques Cailloux, chief European economist at Royal Bank of Scotland Group Plc in London. “Draghi might be reluctant to step up the bond purchases now but if the situation deteriorates further, he will have to.”

To contact the reporters on this story: Matthew Brockett in Frankfurt at mbrockett1@bloomberg.net; Gabi Thesing in Frankfurt at gthesing@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net