ECB likely to leave rates unchanged, urge Italy to stick with reforms despite election

FRANKFURT – The European Central Bank likely won’t offer more help Thursday for Europe’s struggling economy, instead pressing indebted Italy to stick with its efforts to hold down deficits despite voter rejection of tough austerity measures.

Analysts say the ECB will keep its benchmark interest rate at a record low 0.75 per cent when its 23-member governing council meets Thursday in Frankfurt, Germany.

A rate cut is possible on paper since inflation is low at 1.8 per cent and appears headed down — removing the fear that lower rates could stoke inflation. The economy of 17 European Union countries that use the euro is in recession and theoretically could use the stimulus of lower borrowing costs. ECB leaders however have stressed rates are already very low and suggested that further cuts might not do much more good.

Instead, ECB head Mario Draghi is likely to face questions about Italy’s political turmoil and its chance to disrupt the recent calm in the eurozone crisis over too much government debt in some countries.

Draghi is expected to underline that tough requirements will be imposed on any country that wants to use the ECB’s bond-purchase safety net, credited with easing Europe’s crisis over too much government debt.

The ECB President “is likely to point to the conditions, which may be interpreted as a warning to Italy not to reverse reforms,” said Christian Schulz, senior economist at Berenberg Bank in London.

The ECB’s bond purchase safety net announced Sept. 6 gets much of the credit for the recent easing of market turmoil in the eurozone. The bank would purchase unlimited amounts of a country’s bonds from investors, lowering that government’s borrowing costs. The mere existence of the program has lowered borrowing costs, even though no bonds have been bought.

The catch is that any government that wants the help has to agree to steps to reduce debt through pro-growth reforms and by controlling deficits.

However Italy’s inconclusive elections last week raised the fear there might not be a government that would qualify for ECB assistance. The centre-left alliance of Pier Luigi Bersani came in first and will control the lower house, but not the upper house. The centre-left is searching for support that would let it form a government that could pass legislation and govern effectively.

The results showed that more than 50 per cent of the voters supported groups that campaigned against the budget cutbacks and tax increases of Prime Minister Mario Monti.

If the new Italian government refuses to stick to austerity and reform, it might not get ECB help — which could risk a new escalation of the debt crisis.

So far, the promise of the ECB bond purchase firewall has held, keeping a lid on borrowing costs despite market jitters after the election. Italian bonds trade at yields around 4.8 per cent, about 0.4 percentage point above where they did before the election. That is well below the 7 per cent they reached during the worst of the eurozone crisis in late 2011 and early 2012.

Markets have also been reassured since the election by the idea that Italy’s divided politicians would quickly come together and take necessary steps to qualify for ECB help if borrowing costs rose alarmingly. That is what they did in November, 2011. The main parties then installed Monti at the head of a government of finance experts to restore market confidence.

During his 15 months in office, Monti has reduced the budget deficit and passed limited reforms to make the country more business-friendly. The country has already cut its deficit to within the EU limit of 3 per cent and so has few cuts left to make — but markets could become alarmed if Monti’s cuts were reversed.

“The ECB now has to let market discipline run its course,” said analyst Schulz at Berenberg. “If Italy starts reversing reforms, borrowing costs should rise and persuade the country to remain on the path of virtue. “