ECB rate cut expected, but that's about it

@CNNMoneyInvest July 4, 2012: 7:33 AM ET
mario draghi

European Central Bank president Mario Draghi wants euro area governments to reform their economies before monetary policymakers will take more aggressive steps to boost the economy.

NEW YORK (CNNMoney) -- The European Central Bank is widely expected to lower interest rates Thursday, but analysts say ECB officials are unlikely to announce more unconventional moves to stimulate economic activity.

ECB president Mario Draghi and members of the bank's governing council will meet in Frankfurt for their monthly policy discussion. This comes a week after euro area political leaders agreed to move towards a centralized banking authority under the direction of the ECB.

In what many see as a reward for the politicians, the ECB is expected to cut its main lending rate by 0.25% to an all-time low of 0.75%.

But most experts say Draghi will be reluctant to go further before euro area leaders implement the policies they agreed to last week.

"In light of the EU summit, I think the ECB will use conventional methods for now," said Nick Stamenkovic, market strategist at RIA Capital Markets in Edinburgh. However, the ECB could be more aggressive. Stamenkovic expects a half-point rate cut.

Investors have been hoping for coordinated action by central banks to prop up the faltering global economy. The Bank of England will also hold its monthly policy meeting Thursday, and many analysts expect the BOE's Monetary Policy Committee to back additional asset purchases.

However, the market response to a quarter-point cut by the ECB may be muted, said Grant Lewis, head of research at Daiwa Capital Markets in London. "The problems in the eurozone are not about the cost of money in general, but about the cost of money for certain countries, namely Spain and Italy," said Lewis.

To that end, the ECB is not expected to reactivate its controversial Securities Market Program, under which it has purchased billions of euros worth of government bonds, including Spanish and Italian paper.

"I think you can rule out the SMP," said Lewis. "We're not going to get any more bond purchases."

Euro area leaders agreed in principle to allow the European Stability Mechanism, a billion bailout fund that comes into effect July 9, to buy sovereign debt in the secondary market.

Yields on Spanish and Italian bonds have eased since euro area leaders announced the move last week, when they also agreed to withdraw the ESM's preferred creditor status.

While additional bond purchases are unlikely, the ECB could launch a third long-term refinancing operation, or LTRO, according to Holger Schmieding, chief economist at Berenberg Bank.

The ECB recently relaxed its collateral requirements, which could make it easier for banks to access liquidity and buy more government bonds. "Spanish institutions particularly would benefit and potentially drive down sovereign borrowing costs again," Schmieding wrote in a note to clients.

However, Draghi has said repeatedly that ECB analysts are still assessing the impact of the first two LTROs, which funneled over €1 trillion into the banking system starting late last year.

"I struggle to see how another LTRO could be successful," said Lewis. "I still wonder about the appetite and ability for these banks to buy sovereign debt.".

Interest rates: In addition to lowering its refinancing rate, which is what the ECB charges commercial banks to borrow money, the central bank could also cut its deposit rate.

The deposit rate is what the ECB pays banks to hold money in its overnight facility. Some analysts say the rate could be cut to zero from an already low 0.25%.

The goal is to encourage banks to lend excess deposits to businesses and consumers rather than parking money at the ECB, said Natascha Gewaltig, director of European economics for Action Economics.

While the move could cause problems for money market funds, she said "there is now an argument that if the deposit rate is at zero, that will discourage banks from hoarding cash."

However, the concern is that cutting the deposit rate, which serves as a floor for money market funds, could sap liquidity from the interbank market and complicate the ECB's eventual exit strategy.

Meanwhile, the case for a cut in the refinancing rate has been strengthened by the weak economy and relatively modest inflation.

Economic conditions in the euro area have deteriorated, with declines in manufacturing activity pointing to a sharp slowdown in the second quarter.

At the same time, inflation in the eurozone was unchanged in June at 2.4%, while prices fell in Germany and Spain. The ECB's target rate for inflation is 2%, but the central bank has said it expects prices to remain "anchored" in the near-term.

Draghi said after the ECB's last meeting in June that the decision to hold rates steady was not unanimous.

While a rate cut would be welcome, economists say the impact on growth will be relatively modest since monetary policy cannot solve the structural problems in the euro area.

"I don't think it will change the fundamental situation," Gewaltig said. To top of page

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