ECB could cut benchmark rate

By DAVID McHUGH | December 8, 2011 | 1:40 AM EST

FRANKFURT, Germany (AP) — The European Central Bank could step up its efforts against Europe's debt crisis by cutting interest rates on Thursday for the second time in five weeks, and by extending longer-term loans to ease financial pressure on struggling banks.

President Mario Draghi's post-meeting news conference will also be watched closely for any sign that the bank is ready to follow through on his hint that it could do more to help indebted governments by stepping up its limited purchases of government bonds.

That would be on the condition that European Union politicians first agree to tighten the eurozone's rules on government debt. Bigger bond purchases would be a big step that could lower borrowing costs for indebted countries such as Italy, the major focus of the crisis right now.

But a deal on new debt rules won't be sealed until a European Union summit the next day, at the earliest. So the bond question will likely remain open.

The interest rate decision could prove highly interesting all on its own. Some economists think the bank could abandon its historic rock bottom level of 1.0 percent as it recognizes the increasingly dire condition of the eurozone economy.

Many economists predict the bank will likely cut the benchmark refinancing rate, currently at 1.25 percent, by a quarter percentage point at the least.

Some, however, see a half-point cut as a possibility. That would take the rate to 0.75 percent.

Even during the financial crisis of 2007-9, the ECB never lowered the rate below 1.0 percent, where it stood from April, 2009 to April, 2011. By contrast, the U.S. Federal Reserve's key rate is 0-0.25 percent and the Bank of England's 0.5 percent.

After raising rates twice earlier this year under former President Jean-Claude Trichet, the bank cut rates at Draghi's very first meeting Nov. 3. That fed expectations that the leadership change and the steadily deteriorating economy would mean the bank would quickly follow up with another cut Thursday.

Rate cuts stimulate growth by making it cheaper for businesses to finance expansion, and for consumers to borrow and spend. But they can worsen inflation if done at the wrong time; currently, inflation is 3.0 percent, above the bank's goal of just under 2 percent. But the bank forecasts it will fall in coming months.

A cut would stimulate an economy that is slowing under the weight of the debt crisis afflicting its banking system. Growth was a mediocre 0.2 percent in the third quarter from the quarter before, and many economists think the eurozone could slip into recession in the fourth quarter.

Other measures economists think the bank could take include extending credit to banks from the current maximum of 13 months to as long as two or three years. That would give banks ready money for an extended period and improve banks certainty about their finances.

Fears that banks may suffer losses on government bonds has made it difficult for them to borrow normally from other banks or by issuing bonds. And trouble at banks can choke off credit to businesses and hurt growth.

The ECB could also decide to accept more kinds of bonds and other securities that it would accept as collateral for credit to banks. That would also make it easier for banks to borrow.

Draghi hinted in a speech Dec. 1 in Brussels that European leaders needed to agree on "a fiscal compact" on reworked rules that restrain eurozone governments from piling up too much debt. Earlier sets of rules have proved unenforceable.

He then suggested that "other elements might follow, but the sequencing matters."

Markets have seized on that to mean that the central bank might step up its purchases of government bonds. Those purchases drive the bond prices up and their interest yields down. Those yields reflect the borrowing costs that countries would pay when they sell bonds to get money to pay off old bonds that are maturing.

Borrowing costs are what pushed Greece, Ireland and Italy to need bailouts to avoid defaulting on their bonds.

The bank has been reluctant to step up the program, and Draghi and Trichet both stressed it is temporary. The bank is concerned that bailing out indebted governments only takes the pressure off them to make difficult political choices to improve their creditworthiness by reducing the budget deficits — which means increasing taxes and cutting spending.

Bond buys also do nothing to improve their economic growth — the long-term key to managing debt.

Draghi has not made the quid pro quo — bond buys for new debt rules — any more explicit. But he has not corrected the impression that markets have, either.

Not everyone is convinced the market has it right. "I think this nexus might actually be overstated to a certain extent," said Stefan Schneider, chief international economist at Deutsche Bank. "I think the market got carried away in interpreting this as a strong hint that the ECB will step up buying."

He said that if politicians reach a convincing debt solution, investors should start buying government bonds on their own.

"Which doesn't mean that the ECB will not continue buying if market pressure is maintained and for the next weeks and months we will have to expect increasing volatility," Schneider said. "But I think there is no such deal like, 'you do this and we invest X billion euros in government bonds.'"