ECB rate on hold despite deflation danger

July 1, 2009

, FRANKFURT, Jul 1 – Despite a danger of deflation and complaints of tighter credit, the eurozone\’s main interest rate will probably stay at 1.0 percent when European Central Bank governors meet on Thursday in Luxembourg.

It is one of two ECB governing council meetings held outside the bank\’s Frankfurt headquarters each year, and policymakers will gauge the effects of last week\’s record loan operation before taking any more steps.

The ECB held its biggest single refinancing (refi) operation on June 24, lending 442 billion euros (624 billion dollars) for a year at 1.0 percent.

It is unlikely to quickly unveil more measures to boost the recession-hit eurozone economy.

The ECB will also buy 60 billion euros worth of low-risk corporate bonds to prime business finance markets and could press banks to increase lending as signs suggest activity could pick up later this year.

The latest economic data give the ECB reasons to loosen monetary policy further however.

Eurozone consumer prices fell in June for the first time on records that go back to 1996, a Eurostat agency estimate showed Tuesday, raising the spectre of deflation gripping the economy.

The provisional inflation figure of minus 0.1 percent is far from the bank\’s target of just below 2.0 percent.

A broad-based decline in prices can incite households and companies to postpone spending, throttling production and threatening jobs.

After hitting a record high of 4.0 percent in June and July 2008, eurozone inflation plunged to a record low as oil and other commodity prices collapsed in the face of a dire global economic downturn.

Rising unemployment should keep labour costs stifled through next year.

Meanwhile, ECB figures show growth of lending to the private sector slowed in May to just 1.8 percent from the same month a year earlier, though on a monthly basis loans edged up following three months of declines.

Barclays Capital economist Thorsten Polleit said banks were trying to limit risks faced by lending to companies and private individuals.

After getting into trouble through the US subprime crisis and bankruptcy of investment bank Lehman Brothers, "the de-risking of banks\’ balance sheets is firmly underway" now, Polleit told AFP.

The threat is that commercial banks will simply funnel ECB cash into government bonds, 15 billion euros of which they bought in May following 18 billion in April.

"Bank holdings of government bonds are expanding at a rate of 12.7 percent" per year at present, Morgan Stanley economist Elga Bartsch noted.

According to a June survey by Germany\’s Ifo economic research institute however, "credit constraints for German industry and trade are only slightly lower than they were in the previous month."

ECB president Jean-Claude Trichet has urged commercial banks to lend more, and the message has been echoed by governing council members like influential German central bank governor Axel Weber.

Weber warned banks they could find themselves out of the loop, with the ECB lending directly to the private sector if ECB money was not passed on.

"National governors would be in a better position to deliver that message" than Trichet, Polleit said.

As for interest rates, with inflation "set to remain dampened for the foreseeable future and the credit downturn in full swing, we see a strong case for a steady refi rate throughout 2010," UniCredit economist Marco Valli said.

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