New ECB President faces an interest rate dilemma

  • Only a few days after the European Central Bank (ECB) welcomed Mario Draghi as the next president and already focus is turning to his first monetary policy meeting, due this Thursday 3 November at 12.45 GMT. Last month, investors were almost certain they would witness an interest rate cut as the region continued to suffer from a deepening debt crisis. Since then, the situation has deteriorated even further and the question on everyone's mind is whether Draghi will decide to cut interest rates this week.
  • The economic situation in the eurozone appears to be worsening. Even after the EU summit generated a plan to help the eurozone escape its deepening debt problems, the future of the eurozone seems far from promising. During the EU summit, European leaders decided to extend the size of the European Financial Stability Facility to one trillion euro and reached an agreement with private creditors to accept a 50% haircut on Greek debt. Data from the region's Labour sector also raised concerns; unemployment rate was 10.2% in September and seasonally-adjusted unemployment rose by 188,000 to 16.2 million showing that the eurozone is on the verge of recession.
  • Added to this was the shock announcement today from the Greek Prime Minister George Papandreou that the country will hold a referendum to decide whether to approve the strict austerity measures, which are a contingency of the new bailout plan. Papandreou said that the government believes in their citizens and wants them to be a part of the decision, but the wisdom of the planned referendum is questionable at a time of political instability and intense protests about the new austerity measures.  The euro slid after the announcement on growing concerns that a no vote which may result in a Greek default. Uncertainty is now heightened as the risk of a Greek default seems higher than ever, which raises fears about further contagion in eurozone countries.
  • With all of this in mind, Thursday's ECB monetary policy meeting will be watched particularly closely. Will the ECB cut interest rates to boost growth in the eurozone or will Draghi wait until inflation is controlled? Also, what are his plans for the central bank's bond buying programme? Many analysts are speculating that the central bank will announce a 25 basis points interest rate cut and because of this speculation perhaps we will see a muted reaction as this result may already be priced in market expectations. Another scenario is a 50 basis points cut in the benchmark interest rate. This may increase investors' risk appetite as they hope for a eurozone economic recovery, which in turn may support the single currency.
  • Cutting interest rates to boost growth would be an easy decision to make. But what happens if inflation keeps rising? October's data showed that the Consumer Price Index gained 3%, well above the central bank's target of 2%.
  • Investors' real focus will be on the press conference held by the new president which follows the ECB's interest rate price announcement at 13.30 GMT. Draghi is known as a hawk, which means he is believed to favour price stability. The irony is that his decisions will define whether his native country, Italy, will suffer further from the slow growth and an escalating debt crisis in the eurozone. All eyes will be on Draghi at this time as a strong rhetoric to the markets over his monetary strategy is expected. 

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