ECB walks an inflationary tightrope

Europe has the staggers once again with investors ditching Spanish and Italian bonds on a modicum of bad news. And now fuel prices are adding inflationary concerns to the ECB's stimulus measures.

The eurozone debt crisis again turned savage overnight as investors, worried that Spain and Italy are plunging deeper into an economic morass, sold off Spanish and Italian bonds, pushing up borrowing costs for the two countries.

Investors began to worry after a disappointing Spanish bond auction which saw the country sell just €2.6 billion ($US3.4 billion) of bonds at yields that were higher than at recent auctions. As a result, they sold off bonds, pushing yields on 10-year Spanish government debt up by 25 basis points to 5.66 per cent.

Long-term Spanish bond yields are now more than 40 basis points higher than what they were when the European Central Bank launched its first long-term refinancing operation last December.
Italian bonds are also feeling the heat, with 10-year bond yields rising 21 basis points to 5.34 per cent.

Overnight, the ECB – which is trying to balance the growing economic fragility in the eurozone with rising inflationary pressures caused by higher petrol prices – kept the key eurozone interest rate at the record low of 1 per cent.

ECB boss Mario Draghi overnight dismissed concerns about inflation, saying that inflationary expectations remained "solidly anchored”, while the eurozone’s unemployment was high, and that the situation was "weaker than expected”.

It was, he said, "premature” to start thinking about unwinding the measures the ECB had taken to combat the region’s spreading debt crisis.

His comments were targeted at Germany’s powerful Bundesbank, which has publicly called for an exit strategy. The Bundesbank is concerned that the €1 trillion in cheap three-year loans that the ECB has provided to European banks through its two LTRO operations (in December and February) will lead to rising inflation, and excessive risk taking on the part of banks.

Draghi defended the ECB’s actions, saying the two LTRO operations had produced "powerful and complex” effects. However, he cautioned that they only represented "opportunities” for governments "to launch structural reforms and consolidation measures”.

He added that rising pressures in Spanish and Italian bond markets were an "example of the fragility of markets” that were waiting for reforms.

Meanwhile, Italy’s technocratic prime minister, Mario Monti, has insisted that he is looking for ways to stimulate the dismal Italian economy, which now struggling with a 9.3 per cent unemployment rate.
"We obviously cannot ignore social suffering” in the country, Monti said in an interview with the Italian newspaper La Stampa.

He said that his government was looking for ways to boost economic activity, but added that it was important to be very selective "because it isn’t possible to inject public funds” which would increase the budget deficit. Monti also conceded that measures adopted by his government, including cuts in spending and rising taxes, "have, and will have, a recessionary effect”.

But he argued that they were indispensable to reassuring the markets that Italy, which has a debt burden of 120 per cent of GDP, risked being carried away by the storm encircling the eurozone.

As for Rome’s promise to produce a balanced budget by 2013, Monti admitted that this was an "ambitious target” which had been set by his predecessor, Silvio Berlusconi. However, he added that questioning this target could jeopardise Italy’s credibility.

Last month Italy, which is the third largest economy in the eurozone, announced that its budget deficit was reduced to 3.9 per cent of GDP in 2011, from 4.6 per cent the previous year. But many economists are predicting that the country’s deepening recession will slow tax revenues and push up the cost of providing unemployment benefits, making it near impossible for the country to achieve its ambitious deficit reduction plans, particularly since the country’s borrowing costs now appear to be pushing higher.