Thursday, August 2, 2012

ECB sharpening its tools to bring down bond yields

    The European Central Bank (ECB) is in the final stages of deciding which tools it may use to bring down the exceptionally high interest rates that some of the euro zone member states, such as Spain and Italy, are paying to sell their sovereign bonds.
     In a press conference following the bank's decision to maintain its benchmark refinancing rate at 0.75 percent, ECB President Mario Draghi laid out his arguments to explain to fiscal hawks in Europe why the ECB was justified in new measures that would push down bond yields.
     Draghi said risk premia on bonds of some countries in the 17-nation euro zone "hinders the effective working of monetary policy"and the bank's governing council had discussed the various policy options that are available to "address the severe malfunctioning in the price formation process in the bond markets of euro area countries."
    The yield on Spanish 10-year bonds is currently below 7 percent but was starting to approach 8 percent recently. Italy is paying just below 6 percent compared with Germany's 1.3 percent yield.
    Draghi called on euro zone policy makers to push ahead with reform and deficit-cutting efforts but  he acknowledged that this takes time and markets first react when those measures are clearly visible.
    Governments mush therefore be ready to use the euro zone's bailout funds - either the permanent European Stability Mechanism or the current temporary version, the European Financial Stability Fund, - "when exceptional financial market circumstances and risks to financial stability exist," he said.
     He also said that any "risk premia that are related to fears of the reversibility of the euro are unacceptable, and they need to be addressed in a fundamental manner. The euro is irreversible."
    "The Governing Council, within its mandate to maintain price stability over the medium term and in observance of its independence in determining monetary policy, may undertake outright open market operations of a size adequate to reach its objective. In this context, the concerns of private investors about seniority will be addressed," Draghi said, adding: 
    "Furthermore, the Governing Council may consider undertaking further non-standard monetary policy measures according to what is required to repair monetary policy transmission. Over the coming weeks, we will design the appropriate modalities for such policy measures."
    The ECB cut its refinancing rate by 25 basis points on July 5 and Draghi said economic growth remains weak while inflation should fall further below the bank's target of close to 2 percent in 2013.
    "A further intensification of financial market tensions has the potential to affect the balance of risks for both growth and inflation on the downside," he said.
    The inflation rate in the euro zone was steady at 2.4 percent in June but the economy contracted 0.1 percent in the first quarter from the same 2011 quarter. The unemployment rate remained at a record high of 11.2 percent in June but the rate varies greatly across the euro area, from a high of 24.8 percent in Spain to a low of 4.5 percent in Austria.
    "The risks surrounding the economic outlook for the euro area continue to be on the downside. They relate, in particular, to the tensions in several euro area financial markets and their potential spillover to the euro area real economy. Downside risks also relate to possible renewed increases in energy prices over the medium term," he said.


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