Europe's central banks stand firm on rates

mario draghi ecb
The ECB, headed by Mario Draghi, kept rates unchanged at its meeting Thursday

Europe's central banks resisted pressure to do more to support growth, keeping interest rates at record low levels Thursday as evidence emerged that the region's economy may be on the mend.

The European Central Bank left its key interest rate at 0.75%, and the Bank of England held its at 0.5%.

The eurozone economy is set to contract for a second year running in 2013, as recession grips southern Europe while much of the rest of the region is in stagnation. But Europe's biggest economy, Germany, saw a sharp rebound in industrial orders in December, and the purchasing managers' index for the eurozone rose for a third straight month in January.

"We see a gradual recovery in the second part of this year," ECB President Mario Draghi told reporters, adding the risks to the outlook were still tilted to the downside.

Another sign of a return to more normal financial conditions came last week, when eurozone banks repaid €137 billion in emergency 3-year loans issued by the ECB a year ago in the middle of the credit crisis.

Related: 'Jury still out' on eurozone - Draghi

The shrinking of the ECB's balance sheet and refusal to relax policy further to help lift the eurozone economy out of recession have combined with a return of investor confidence to push the euro to 14-month highs against the dollar.

The strong euro has prompted some European politicians to voice concerns about the impact on exports and to call for an exchange rate policy. France has promised to raise its concerns at a meeting of G-20 nations later this month.

Draghi said he did not believe recent sharp moves in currency markets were the result of deliberate competitive devaluations, but the ECB would monitor their impact closely.

"They are more the effect of macro policies that are meant to revamp the economies.... such as very low interest rates or the adoption of an inflation target which is distant from current inflation rates," he said. "We will certainly want to see if the appreciation, if sustained, alters our risk assessment as far as price stability is concerned."

Draghi rejected suggestions he had failed when head of the Bank of Italy to oversee Monte dei Paschi di Siena, the bank at the center of a political scandal that could affect the outcome of crucial Italian elections later this month.

"You should certainly discount much of what you hear and read... as part of the regular noise that elections produce," he said.

The Bank of England also resisted pressure to extend its government bond-buying program, leaving the volume at £375 billion, but said it was ready to provide further monetary stimulus if needed.

The U.K. economy contracted by 0.3% in the fourth quarter of 2012, bringing to the brink of a third recession in five years.

"The [bank] continues to judge that the U.K. economy is set for a slow but sustained recovery," it said in a statement. "But the risks are weighted to the downside, not least because of the challenges facing the euro area."

Related: Europe: No retreat from austerity

U.K. manufacturing output bounced back in December -- rising 1.6% after a decline of 0.3% in November -- reducing the risk of a second consecutive negative quarter for gross domestic product.

Still, given the government's determination to push ahead with its austerity program, some analysts say the bank might need to pump more cash into the economy.

"Overall, in the current economic situation, further expansion of the asset purchase program would be warranted if the economy stays weak," the OECD said this week.

The weaker economy is already throwing the government's fiscal plans off course. The Institute for Fiscal Studies said Wednesday the U.K. would borrow £64 billion more than planned in 2014-2015 unless further spending cuts or tax rises were implemented.

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