European Central Bank President Mario Draghi is trapped between accelerating inflation and slowing growth, making it hard for him to defend countries such as Italy and Spain from the ravages of recession.
The central bank yesterday revised its inflation forecast for the euro area to an average rate of 2.4 per cent this year, up from a December prediction for prices to rise by two per cent. The new projections show the economy may contract 0.1 per cent, down from a previous forecast for 0.3 per cent growth.
With at least six of the 17 euro nations in recession, the latest forecasts may mean Draghi, who cut interest rates at his first two monthly meetings as head of the central bank, won't be able to reduce borrowing costs further as efforts to resuscitate growth by lending unlimited funds to banks lose steam.
"There is not much Draghi can do about the situation really, and the best he can do is doing nothing and see how the liquidity measures play out," said Frances Hudson, a strategist at Standard Life Investments in London, which has $242 billion in assets. "Combined that with the global economic backdrop where growth remains fragile, the danger is that the debt crisis could drag on longer than previously envisaged."
Bond investors are starting to demand higher compensation to protect against a rise in consumer prices. The yield difference between two-year German bonds and index-linked securities of the same maturity advanced to 1.11 percentage points on Saturday, the most since January 26.
Yield shifts
The extra yield investors demand to hold Spanish 10-year debt rather than German bunds has dropped to 315 basis points, from the euro-era record of 503 basis points on November 18. The yield premium Italy pays to Germany is down to a six-month low of 2.87 percentage points, with Italy's 10-year borrowing cost down to the lowest in nine months, declining to 4.68 per cent.
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After flooding financial companies with more than Euro 1 trillion ($1.33 trillion), the ECB is now confronted with oil prices that have climbed by about 27 per cent in the past six months when measured in the common currency. Oil for April delivery rose to $106.93 a barrel in New York, marking a 7.9 per cent increase this year in dollars.
Contracting economies
"Owing to rises in energy prices and indirect taxes, inflation rates are now likely to stay above two per cent in 2012, with upside risks prevailing," Draghi said yesterday. "Available survey indicators confirm signs of stabilisation in the euro area economy. However, the economic outlook is still subject to downside risks."
The euro region will shrink 0.3 per cent this year, down from a November estimate for growth of 0.5 per cent, according to European Commission forecasts. Spain's economy contracted 0.3 per cent in the fourth quarter of last year, while Italy shrank 0.7 per cent, the European Union said on March 6. The region's inflation rate was at 2.7 per cent in January, while the ECB aims to keep it just below two per cent.
"Growth is the big question mark going forward," said Charles Diebel, head of strategy at Lloyds Banking Group Plc in London. "Structural reforms take time to work and there's no magic growth bullet lying around that they can fire."
The so-called five-year, five-year forward breakeven rate, one of the key indicators the ECB monitors, has risen. The rate, which measures inflation expectations for the five-year period beginning in 2017, rose to 2.63 per cent last month, the most since March 2010. That's higher than in April and July of last year, when the ECB raised interest rates. It was at 2.40 per cent on Saturday, up from 2.29 per cent at the start of the week.
'Rates on hold'
"We expect the ECB to keep interest rates on hold for the foreseeable future," said Nick Kounis, head of macro research at ABN Amro NV in Amsterdam. The ECB is signaling that "it has done enough," he said. The central bank's key interest rate is one per cent.
The liquidity measures that the ECB provided have helped to bring down Italian and Spanish bond yields from the euro-era records seen in November as banks used the loans which cost one per cent to borrow to buy higher-yielding assets.