PARIS (MNI) – Senior ECB officials are still on the defensive three
weeks after the bank announced its controversial decision to buy
sovereign debt, even as the pace of the bond purchases shows signs of
slowing.

Several top Governing Council members have appeared in public this
week, insisting that the decision was made under exceptional
circumstances, that it was temporary, and that it compromised neither
the ECB’s independence nor its inflation fighting credentials.

The Council’s leading opponent of the bond purchase measure,
Bundesbank President Axel Weber, renewed his public criticism,
demonstrating that divisions among top policy-makers persist.

The ECB today sterilized E35 billion worth of bond purchases by
collecting precisely that volume of cash from banks in one-week term
deposits. But interest could be waning: bids from banks today were only
2.1 times the amount of deposits accepted, compared with 3.25 times last
week and 10 times in the first week of the bond purchase program.

Today’s total deposits include E8.5 billion for bonds purchased by
the ECB and settled last week — down from E10 billion the week before
and E16.5 billion in the first week of bond buying.

“At first sight I would interpret this as a stabilization of
markets,” Governing Council member Ewald Nowotny told reporters today on
the margins of an event sponsored by the Austrian National Bank, which
he heads.

Many of Nowotny’s ECB colleagues were also out on the hustings this
week, defending the central bank’s decision and its very reputation.

Bank of France Governor Christian Noyer, speaking in Korea, said
ECB President Jean-Claude Trichet had been “absolutely right” when he
declared just three days before the bond purchase program was announced
that such a plan hadn’t even been discussed. Trichet has taken a lot of
flak for that comment, including calls for his resignation.

“What changed …was simply that in a couple of days — and we know
how quickly markets can change — the whole function of important
sectors of the market were dramatically blocked,” Noyer said. The ECB
was “extremely reactive and totally pragmatic,” and it decided to change
tack because “the transmission mechanism of our monetary policy simply
couldn’t work at all,” he added.

Trichet himself said the ECB acted to avoid growing risks to price
stability and that it was “fully independent” in its decision. The bond
purchases “should not be confused with quantitative easing,” he
insisted. “In simple words: we are not printing money.”

Bank of Italy Governor Mario Draghi jumped into the fray, asserting
that the ECB’s monetary policy transmission had been “endangered” and
“the very stability of the euro’s financial system was at risk.”

Weber, considered by many as the leading contender to succeed
Trichet at the helm of the ECB, took a jab at his Council colleagues,
saying that he still viewed their majority decision “critically, given
the stability risks [the bond purchases] entail.”

What they all agreed on was the need to wind down the bond
purchases soon. Trichet said the securities purchase program was
“time-bound.” Draghi said it must be “discontinued as quickly as
possible, as soon as the markets spontaneously resume trading of the
securities of the countries involved.” Weber said it “should not exceed
tightly defined limits.”

As they aired their justifications, concerns and differences, fresh
economic data suggested that the Eurozone recovery may be losing some
steam.

May’s Eurozone manufacturing PMI dropped sharply to 55.8 from
April’s near four-year high of 57.6, highlighting the recovery’s
fragility, according to Markit Economics, which produces the PMI
reports. While the figure shows the recovery continued in May, the
slowdown in the output index was nonetheless the second sharpest since
the PMI surveys started in 1997.

Output and order growth weakened in all Eurozone countries, with
the steepest slowdown registered in Germany, which has been largely
driving the recovery.

Meanwhile, the European Commission’s Economic Sentiment survey for
May showed erosion in all sectors except industry. The sovereign debt
crisis and the intensification of austerity programs in many Eurozone
countries are weighing on consumer sentiment and medium-term growth
prospects, even in Germany, and the economic fallout could be felt in
the months to come.

The Eurozone’s unemployment rate rose to a 10-year high of 10.1% in
April. With the economic recovery as uncertain as it is, the upward
trend in unemployment — though not as steep as previously feared — is
likely to continue for some time.

On a bright note, in Germany 45,000 people left the ranks of the
jobless in May, reducing the unemployment rate to 7.7% — well below the
Eurozone average. This could potentially help stimulate largely moribund
consumer demand, though German retailers remain pessimistic.

Despite a rise in the Eurozone’s May HICP inflation rate to 1.6%
from 1.5% in April, inflation is unlikely to be a significant worry for
some time to come. The rise was due mostly to higher commodity prices,
which have since reversed course amid fear of falling world demand; this
trend will help offset the potentially inflationary impulses of a
cheaper euro.

M3 money supply continued to contract in April (-0.1%, as in
March). Despite the fact that credit to the private sector expanded by
0.1% — the first increase in nine months — there is little evidence of
any inflationary pressure coming from the money and credit side.

Indeed, a subset of European banks is still starved for cash, as
evidenced by Tuesday’s weekly ECB refinancing operation. Even as the
central bank drained E35 billion to sterilize bond purchases, it awarded
E117.7 billion in new one-week refis — a net injection of E11.7
billion.

In its Financial Stability Review, published Monday, the ECB
estimated that euro area banks still were facing E123 billion worth of
new write-offs for bad loans this year and E105 billion next year. The
non-performing assets could be a “lasting drag” on bank profitability,
the ECB said. The report also warned that large-scale government
borrowing could “crowd out” private credit, which might in turn hit
economic growth.

All in all, not a very pretty picture.

Bottom line: with a vulnerable banking sector, a fragile economic
recovery and the ECB still propping up the sovereign bond market, there
is a little prospect of higher interest rates or any significant
tightening in liquidity conditions on the horizon.

–Paris newsroom, +331-42-71-55-40; bwolfson@marketnews.com

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