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European Market Insight: ECB Keeps Rates on Hold

Stocks digest rains of first trading week

By Valnetin Schmid
Epoch Times Staff
Created: January 14, 2013 Last Updated: January 14, 2013
Related articles: Business » Economy & Trade
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Mario Draghi, President of the European Central Bank (ECB), speaks to the media following a meeting of ECB leadership at the European Central Bank on Jan. 10 in Frankfurt. (Hannelore Foerster/Getty Images)

Mario Draghi, President of the European Central Bank (ECB), speaks to the media following a meeting of ECB leadership at the European Central Bank on Jan. 10 in Frankfurt. (Hannelore Foerster/Getty Images)

The European Central Bank kept the main refinancing rate steady at 0.75 percent. According to ECB president Mario Draghi, there are no immediate risks in Spain and Italy.

Markets proved him to be correct as the euro appreciated and Italian and Spanish bond yields stayed low. The euro gained 2.2 percent to close at $1.3354, resuming its steady uptrend from the late summer. Italian and Spanish bond yields are at lows not seen since the start of 2011. European equities digested their gains from the first week of the year, rising a modest 0.3 percent.

Draghi did not exactly paint a rosy picture. He was quite vocal, however, in pointing out that nobody on the governing council had considered a rate cut of the main refinancing rate to 0.5 percent. The bottom line of the ECB assessment is to expect a small improvement in 2013 and no escalation of the sovereign debt crisis.

All of this helped the euro versus the U.S. Dollar. When macroeconomic shocks are absent, as they seem to be at this moment, the market goes back to focusing on fundamentals, such as interest rates.

Short term central bank rates are 0.75 percent in Europe and around zero in the United States. Spreads between German and U.S. ten year bonds have risen, meaning that German bonds yield relatively more and are therefore more desirable for international investors. On the margin, this has moved investors to shift dollars into euros.

No Lending Despite Low Rates
For global markets, confidence in the euro as a currency is good news. The underlying economy, however, might need lower rates.

First, a higher euro hurts exporters. If customers have to pay more dollars for a product, even if the price in euros doesn’t change, they might shop at home or buy from elsewhere. A crashing euro on the verge of collapse is in nobody’s interest, but in principle, a lower euro driven by lower interest rates might help get the economy out of recession.

Given relatively low inflation, but record-high unemployment in Europe, lowering rates might help to spur credit creation. This credit would ideally be lent to businesses and households which could translate into real economic activity. The so called “Taylor Rule” named after U.S. economist John B. Taylor is a relatively simple formula describing the relationship between inflation and interest rates. Under this rule and adjusted for unemployment, the ECB should lower rates.

Draghi has been reluctant to provide these lower rates, however. Banks in the north are awash with cash and there is little demand for loans whereas banks in the South will not lend out the money as their balance sheets are impaired already from earlier loan binges and unproductive investments. The result is that low rates will benefit banks, but won’t filter through to the real economy.

Despite a calm start to the year and little bad news on the sovereign debt front, the conclusion for Europe remains the same. The imbalances created by the fixed exchange rate system that is the euro have to be solved; otherwise there won’t be a return to growth.

The Week Ahead
This week will be relatively calm in terms of data, but releases such as car registrations and industrial production figures will provide a glimpse of where the European economy currently stands.

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