By Colin Barr
December 2, 2010

The euro slipped against the dollar after European Central Bank chief Jean-Claude Trichet failed to deliver a hoped-for ECB rescue of the bond market.

The euro slipped to $1.30 from $1.31 Wednesday. It has slipped 7% over the past month as questions about the health of the European banking system have renewed speculation that the euro zone may collapse.

Trichet (right), as he often has throughout the financial crisis, took a cautious stance in spite of the calls for strong action from the central bank.

He said at a press conference in Brussels Thursday that the ECB would delay by three months its plan to reduce liquidity support for European banks. The central bank’s expanded lending to cash-strapped banks will continue through the first quarter, he said.

But Trichet didn’t show any inclination to follow in the footsteps of the Federal Reserve and soak up a growing supply of government bonds by committing to an expanded bond-purchase program. The weakest European economies face hundreds of billions of euros of debt maturities next year.

European bond markets have been in an uproar for the past week, as the prices of bonds issued by weaker governments such as Ireland, Portugal and Spain have tumbled amid questions about their economic prospects at a time of widespread retrenchment.

The sovereign bond selloff has come in spite of a $100 billion-plus rescue package extended to Ireland, and even as ministers in Portugal and Spain have insisted they won’t need to take funds from the European Union or the International Monetary Fund.

The failure of the Irish bailout to quiet contagion fears in Europe has prompted calls for European leaders to take a more strategic approach to the crisis, which has centered on the government bond market but is being driven by fears that strapped European governments will have to bail out overextended banks for the second time in three years.

Trichet spoke earlier this week of European policymakers’ efforts to make sure the euro zone remains stable, raising hopes that the ECB might turn its firepower on the bond market.

“President Trichet’s comments in European Parliament on Tuesday, that financial stability is not in question and that there is a ‘determination’ among euro area officials, have raised speculation that the ECB could announce an expanded bond purchase plan,” Tullett Prebon economist Lena Komileva wrote.

But Trichet said Thursday that the ECB will continue sterilizing whatever bond purchases it makes, which is to say that it will sell short-term debt into the market to soak up the new euros it prints to buy the bonds.

The effect of that policy is to hold the monetary base neutral, which Trichet and his peers on the ECB justify in the name of holding down the potential for an inflationary spike.

But with consumers and businesses cutting debt rather than spending money on goods and services, and the banks still struggling under the weight of bubble-era bad loans, this strategy runs the risk of exposing a soft European economy to a new financial shock.

Trichet didn’t rule out further actions, however, and many observers expect the ECB to be forced into Fed-like bond purchases before long, in the name of propping up banks that are undercapitalized and heavily exposed to the sovereign bonds of weaker countries.

“We will remain alert permanently,” Trichet said.

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