Inflation slump tests ECB's readiness to act

By Paul Carrel

FRANKFURT (Reuters) – The spectre of deflation gripping the euro zone hangs over European Central Bank policymakers meeting this week and may even jog them into fresh action to pep up the bloc’s weak economic recovery.

A fall in euro zone inflation to 0.7 percent last month – far below the ECB’s target of just under 2 percent – highlighted the risk and led some analysts to predict an interest rate cut at Thursday’s policy meeting.

Emerging market turmoil will also be high on the 24-member Governing Council’s agenda since, if it forces the euro higher, that could put more downward pressure on prices.

If the January inflation fall is not enough to prompt a policy response, the 24-member Governing Council may be swayed by updated economic projections from the bank’s staff in March.

Last month, ECB policymakers beefed up their commitment to take action should inflation risk turning into deflation or rising money market rates threaten the bloc’s fragile recovery.

“They know there are risks here to the downside, so I think on balance they’ll take the bold step (and act now),” said RBS economist Richard Barwell, who was one of the few economists to forecast the ECB’s last rate cut, in November.

Barwell forecast a cut this week in the main rate to 0.10 percent from 0.25 percent, with the deposit rate the ECB pays banks for holding their cash overnight remaining at zero.

A survey released last month showed the euro zone’s private sector started 2014 in much better shape than expected, with stronger growth across the region marred only by a continued downturn in France.

Although the ECB cut rates in November after a drop in inflation to 0.7 percent a month earlier, ECB policymakers focus on the medium-term outlook rather than monthly price swings.

Deutsche Bank economists Mark Wall and Gilles Moec said in a research note that the data released over the last month justified the ECB easing policy at Thursday’s meeting.

“It is a question of timing. If not February, the easing will be in March, accompanying downwardly revised ECB staff inflation forecasts,” they said.

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After the January policy meeting, President Mario Draghi set out two scenarios that could trigger fresh policy action: a deterioration in the medium-term inflation outlook and an “unwarranted” tightening of short-term money markets.

“Every incremental step that headline inflation takes lower, the risk of getting into a (deflationary) tailspin creeps higher,” said Barwell at RBS.

In money markets, the second potential trigger for action, a reduction in the amount of excess cash sloshing around in the financial system put upward pressure on overnight lending rates early this year.

But banks stocked up on ECB cash last week and are easing back on early repayments of ECB crisis loans. Together, these factors are expected to keep enough excess cash in the system to hold down short-term market rates.

Draghi and other ECB policymakers have stressed the “weak, fragile and uneven” nature of the recovery.

Benoit Coeure, who sits on the six-member Executive Board that forms the nucleus of the broader ECB Governing Council, last Friday stressed central banks’ ability to act even when interest rates are at zero.

“There are monetary policy instruments that could be used in the event of downward risks to medium-term price stability, even if the nominal interest rate is constrained by the zero lower bound,” Coeure said in Ljubljana.

Beyond cutting interest rates, the ECB has a range of other policy options it could use including offering banks another batch of LTRO long-term loans – a move that could ease money market tensions – or asset buys, to tackle the deflation risk.

A further possibility could be to stop weekly operations that sterilise the ECB’s holdings of government bonds bought under a terminated bond-buy programme – a step that could increase the money supply and fuel inflation.

However, many analysts see no need to act yet. A Reuters poll of 76 economists taken last week pointed to no change in ECB rates unless market rates and the euro rise.

“We are not expecting any action,” Berenberg bank economist Christian Schulz said of Thursday’s policy meeting. “Rising confidence and falling unemployment point to a strengthening and broadening recovery at least in line with ECB forecasts.”

(Editing by Mike Peacock)

Inflation slump tests ECB's readiness to act