ECB's Draghi Says Central Bank's Response is Limited But Hints at 'The Bazooka'

In a speech to the European Parliament in Brussels Thursday, new ECB President Mario Draghi offered conflicting remarks on the outlook for the central bank to play a more meaningful role in fighting the sovereign debt crisis, but gave traders reason to hope that “the bazooka” might be employed at some point soon.

On one hand, Draghi appeared to make it clear in the speech that the central bank does not plan to backstop the bond market and urged governments to pursue a deeper fiscal union to solve the debt crisis. The ECB President said that while the ECB is buying bonds to improve the transmission of its interest rates, "such interventions can only be limited".

On the other hand, Mr. Draghi did appear to hint that the ECB would be willing to up the central bank’s efforts – IF tighter budget controls were to be put in place.

Specifically, Draghi called for a new "fiscal compact" between governments to restore investor confidence in the Eurozone. The FT noted this morning that Draghi hinted such a move could pave the way for a more aggressive ECB response to the debt crisis. The ECB head argued that a new fiscal compact would be “definitely the most important element to start restoring credibility," adding that “Other elements might follow, but the sequencing matters".

The ECB President also made the point that the economic risks in the Eurozone were to the downside. Draghi said that risks to the economic outlook have increased and said that the ECB would ensure that inflation did not undershoot its target or exceed it. The markets appear to be interpreting these comments as raising the chances that the ECB will announce another rate cut at next week's meeting.

A Reuters article pointed out that Draghi did not spell out what action the ECB might take should a “fiscal compact” be agreed to by EU leaders at the upcoming summit. However, Reuters notes that the central bank is under meaningful political and market pressure to ramp up the SMP or to lend money to the IMF to support Italy and Spain.

The FT is saying this morning that after two days of meetings, the European finance ministers appear to be settled on the view that the ECB should be the “lender of last resort”, which can save the Euro. The paper added that the shift came as Italy's new government received a dire warning from the EU to reform its economy quickly or face a "full-blown" liquidity crisis.

The FT also points out that a growing number of EU officials talked up the idea of the central bank having ability to dampen the crisis, either alone or in combination with the IMF and EFSF.

The bottom line here appears to be that despite continued public objections from the ECB, European officials are hoping that plans for deeper fiscal integration and discipline will compel the central bank to act in the coming days. Based on the action in the stock markets this morning, traders are buying into this theme.

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