The other interest rate to watch

Any satisfaction stemming from the European agreement will be short lived, as Italy and Spain look to the European Central Bank to critically sweeten the deal their leaders made last week.

ItaIian leader Mario Monti and his Spanish counterpart Mariano Rajoy will be hoping to sweeten their victory at last week’s European summit with an interest rate cut by the European Central Bank at its board meeting on Thursday.

Last Thursday night, the affable Monti, backed by Rajoy, surprised many by standing up to German Chancellor Angela Merkel, and refusing to sign the European growth pact unless she agreed to concrete steps that would reduce borrowing costs for Italy and Spain.

After ten hours of arduous negotiations, Merkel capitulated. She agreed that in future debt-laden eurozone countries, such as Italy and Spain, will be able to request Europe’s bailout fund to buy their bonds, without having to suffer the humiliation of agreeing to an official austerity program supervised by the "troika”. Markets celebrated when they heard of Merkel’s back-down, with Italian and Spanish bond yields dropping sharply.

But Monti and Rajoy know this is not enough. They know that it’s a matter of time before investors again start worrying about the moribund Italian and Spanish economies, and their heavy debt burdens, and their borrowing costs start to climb again.

They know that their only hope is for the European Central Bank to cut its key interest rate below the 1 per cent thresh-hold – to 0.75 per cent, or, even better, to 0.5 per cent. Although the rate cut would have little effect on boosting economic growth, it would provide some relief for struggling Italian and Spanish banks that are heavily dependent on borrowing from the central bank. What’s more, they’re hoping that a rate cut might cause the euro to drop sharply, which would make their exports more competitive on global markets.

Certainly, the latest figures support a cut in rates. The latest figures show that the eurozone’s unemployment rate hit 11.1 per cent in May, while the jobless rate for those under 25 years of age surged to 22.6 per cent. Jobless numbers for the region are now at their highest levels since records began in January 1995.

Analysts are worried that the eurozone’s unemployment rate will continue to climb as debt-laden governments cut spending in a bid to reduce their yawning budget deficits and as companies, faced with a collapse in demand for their products, lay off workers.

This fear was reinforced by Markit’s manufacturing purchasing managers’ index (PMI) – an important indicator of how businesses are faring – which showed that activity at eurozone factories continued to decline sharply in June. Even Germany – the eurozone’s strongest economy – is now feeling the pain, with manufacturing activity falling at its fastest rate in three years.

Many economists believe that the eurozone, where growth was stagnant in the first three months of the year after a 0.3 per cent decline in the final three months of 2011, is now at risk of plunging into a deep recession.

Many are tipping that the region will suffer an economic contraction of at least 2 to 3 per cent this year, or even worse if Germany suffers an export-led recession. Given that many eurozone countries, including Italy and Spain, only managed to achieve a modest rebound from the 2007-8 recession, this means that the region’s economic output will drop to new lows.

Monti and Rajoy know that the deal hammered out at last week’s European summit is likely to provide only a temporary respite from the region’s ongoing debt and banking crisis.

They know that the only hope they have for rescuing their countries from a deepening debt crisis is for the euro to fall sharply, which would boost their international competitiveness and allow them to sell more exports.

That’s why, for them, this week’s interest rate decision by the European Central Bank is crucial.

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