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ECB Keeps Rate at 1% as Crisis Threatens to Derail Recovery

The European Central Bank left interest rates at a record low as rising market borrowing costs and the sovereign debt crisis threaten to derail the region’s economic recovery.

Policy makers meeting in Frankfurt today kept the benchmark rate at 1 percent, as predicted by all 55 economists surveyed by Bloomberg News. Separately, the Bank of England left its key rate at 0.5 percent. ECB President Jean-Claude Trichet holds a press conference at 2:30 p.m.

Trichet is under pressure to do more to shore up investor confidence in the 16-nation euro region as government spending cuts and concerns about the health of the banking sector cloud the outlook for growth. The International Monetary Fund said yesterday the ECB may have to step up its purchases of government bonds, which have already split the bank’s 22-member Governing Council.

“We’re lacking the sense that the ECB is prepared to do what is necessary,” said Ken Wattret, chief euro-area economist at BNP Paribas in London. “It still seems very uncomfortable with the asset purchases and rising market rates are an additional concern. Monetary policy should be a lot looser.”

Signs of Weakness

Europe’s economy is showing signs of weakening after Greece’s fiscal crisis drove up bond yields in debt-strapped countries and forcing governments to implement austerity measures. Growth in the service and manufacturing industries slowed for a second month in June.

The ECB’s unprecedented decision to start buying government debt on the secondary market on May 10, which wasn’t supported by all of its policy makers, has so far met with limited success. The extra yield that investors demand to hold Spanish 10-year bonds over the German equivalents was at 203 basis points today, higher than it was before the ECB started its purchase program.

“Markets are not yet convinced of the central bank’s commitment to scaling up purchases if necessary to prevent a further deterioration of market functioning,” the Washington- based IMF said in a report yesterday.

Bundesbank President Axel Weber and ECB Executive Board member Juergen Stark have both criticized the bond purchases, saying they pose significant risks to the bank’s credibility. The ECB bought 4 billion euros ($5 billion) of bonds last week, matching the lowest weekly amount since the program began and bringing the total amount purchased to 59 billion euros.

Market Rates

Interbank borrowing costs have also been climbing since financial institutions had to pay back a record 442 billion-euro ECB loan on July 1, reducing excess liquidity in the system.

The European Overnight Index Average rate, or EONIA, jumped to 0.542 percent on June 30 from as low as 0.295 percent on June 3. The rate that banks charge each other to borrow for three months has increased to 0.8 percent, the highest in 10 months, from 0.63 percent at the end of March. Citigroup Inc. forecasts that the overnight rate will rise to 0.8 percent by October.

“It’s the last thing the economy needs right now and the question is really whether the ECB will tolerate rising interest rates,” said Juergen Michels, chief euro-area economist at Citigroup in London. “It’s not only about at what rates banks lend to each other overnight, a lot of private sector investment hinges on three-month rates.”

ECB Loans

The ECB, which no longer gives banks 12-month loans, could look at a new six-month offering in an effort to boost liquidity and damp market rates, according to Citigroup and Commerzbank AG. The ECB has already committed itself to another three unlimited three-month loans fixed at its benchmark rate.

European Union regulators are carrying out stress tests on 91 banks to examine whether they can withstand a shrinking economy and a drop in government bond values. Regulators are counting on the tests on firms including Madrid-based Banco Santander SA and Frankfurt-based Deutsche Bank AG to reassure investors that banks have enough capital to withstand a debt default by a European country.

The ECB is unlikely to extend any more help to Europe’s banks until after the results of the stress tests are published later this month, said Paul Donovan, deputy head of global economics at UBS AG in London.

“It needs to keep its powder dry,” he said. “If there’s any kind of adverse market reaction, then the ECB is going to need some kind of policy response.”