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ECB leaves Interest rates unchanged, shelving plan for increase

Thursday, September 6, 2007

The European Central Bank left interest rates unchanged today, shelving plans for an increase as the U.S. housing slump threatens to curb economic growth. Policy makers meeting in Frankfurt kept the benchmark refinancing rate at 4% but a survey shows that the bank may raise the rate to 4.25% in October.

The collapse of the U.S. subprime-mortgage market has made banks reluctant to lend, pushing up the cost of credit and causing turmoil on world financial markets. The ECB earlier today added 42.2 billion euros ($ 57.7 billion) in emergency cash to ease a credit drought that had pushed overnight deposit rates to a six-year high.

"The ECB finds itself in a dilemma," said Rainer Guntermann, an economist at Dresdner Kleinwort in Frankfurt. "Economic fundamentals require at least one more rate increase and inflation concerns haven't eased. On the other hand, it needs to deal with market turbulence." Trichet will hold a press conference at 2:30 p.m. in Frankfurt to explain today's decision. ECB President Jean-Claude Trichet on Aug. 27 retreated from a stance of "strong vigilance" on inflation, language he used to signal previous rate increases. Central banks worldwide are refraining from raising rates as they assess how the credit squeeze will affect economic growth.

The Bank of England today left its benchmark lending rate at 5.75%, and in Indonesia the central bank kept its key rate at 8.25%. The Australian and Canadian central banks also opted yesterday to keep borrowing costs unchanged. The Bank of Japan last month stepped back from plans to raise interest rates.

U.S. Federal Reserve chairman Ben S. Bernanke said on Aug. 31 that the bank will do what's needed to prevent the credit rout from undoing America's six-year economic expansion. Concern that defaults on U.S. home loans to people with poor credit histories would curb growth in the world's largest economy prompted a slide in stock and commodity markets and pushed up corporate borrowing costs in early August.

Central banks added more than $ 400 billion to money markets since Aug. 9 to ease lending between banks. Australia's central bank said today it will buy debt backed by home loans to add cash to the financial system. While those actions succeeded in reducing money-market rates for a time, by yesterday the overnight deposit rate for euros had climbed to 4.68%, the highest in six years. It fell to 4.10% after the ECB's injection today.

"The key question is now whether the ECB keeps its finger on the rate trigger, hoping conditions will return to normal quickly, or whether it thinks market volatility will spill over into the real economy," said James Nixon, an economist at Societe Generale SA in London. The ECB will publish new growth and inflation forecasts today, its first estimate of how the credit squeeze may affect the economy.

In June, the ECB predicted economic growth of about 2.6% in 2007 and 2.3% in 2008, and said inflation would average about 2% this year and next. The bank aims to keep inflation below 2%. In 2006, growth reached 2.7%, the most since the turn of the decade. Since then, Europe's economy has cooled. The expansion ebbed to 0.3% in the second quarter from 0.7% in the first. Manufacturing and service-industry growth slowed in August, and consumer and business confidence dropped more than economists forecast. German manufacturing orders dropped the most in at least 16 years in July, a government report showed today.

The Organization for Economic Cooperation and Development yesterday lowered its forecasts for U.S. and European economic growth and said they may be reduced further following the rout on financial markets. "Downside risks have become more ominous," Jean-Philippe Cotis, the OECD's chief economist, said in Paris. For now, "the euro-area economy is still growing at an above-potential rate," said Kenneth Broux, an economist at Lloyds TSB Bank Plc in London. "The current turbulence is a short-term issue, it's not going to derail economic expansion. Growth will re-accelerate in the third quarter." Klaus Baader, chief European economist at Merrill Lynch and Co. in London, said concerns that expensive credit will prevent companies from investing are misplaced.

The ECB has cited credit growth as an inflation risk. Loans to the private sector grew 10.9% in July from a year earlier, the bank said. M3 money-supply growth, which the ECB uses as a gauge of future inflation, accelerated to the fastest pace in 28 years. The bank is also concerned that economic growth will allow companies to pass on higher costs to consumers, boosting inflation. Oil prices have surged 51% since mid-January.

Posted by FR at 7:16 PM  

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