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ECB finally ready to act to fight deflation: analysts

Financial markets are betting on an interest rate cut from the European Central Bank next week as low inflation, the strong euro and anaemic credit finally spur it into action.

FRANKFURT: Financial markets are betting on an interest rate cut from the European Central Bank next week as low inflation, the strong euro and anaemic credit finally spur it into action.

The ECB has held its key interest rates steady at their current all-time lows since November, repeatedly promising to act if necessary to avert deflation in the 18 countries that share the euro.

Inflation is still way below the ECB's target of 2.0 per cent and shows little sign of picking up any time soon.

Hence, ECB president Mario Draghi more or less pre-announced a move at the bank's last policy meeting, saying the central bank's decision-making governing council was "dissatisfied" with the current path of inflation and was "not prepared to accept it as a fact of nature."

But the precise method and extent of any monetary easing would depend on the ECB's updated inflation forecasts, scheduled for next week, Draghi said.

"I would be very surprised if nothing happens" at the meeting on Thursday, UniCredit economist Marco Valli told AFP.

"The markets would not take it very well."

Capital Economics economist Jennifer McKeown agreed.

"It would be a shock if the ECB failed to act this month," she said.

"Economic conditions in the eurozone certainly justify strong action, especially inflation persistently below 1.0 per cent since October," said IHS Global Insight analyst Howard Archer.

"And if the ECB fails to deliver having built up expectations, it risks upsetting the markets and also denting its credibility."

A range of data last week backed up the need to act.

Area-wide growth came in at a disappointingly meagre 0.2 per cent. Money supply growth -- which the ECB uses as a guide to future inflation -- was anaemic. And loans to the private sector, hitherto the stumbling block to a more sustained recovery, continued to fall.

These were all reasons to act, said Archer.

The biggest headache for the ECB is the threat of deflation.

Eurozone inflation picked up only marginally to 0.7 per cent in April, well below the 2.0 per cent that the ECB defines as being in line with price stability.

In a period of deflation, when consumer prices fall for a broad range of items over a sustained period, people and businesses tend to postpone purchases while hoping for further price declines in the future.

Deflation can thus push an economy into a vicious spiral of falling growth and rising unemployment, and it is notoriously difficult to reverse.

Commerzbank economist Michael Schubert said it was time for the the ECB to follow up words with action.

"We expect the ECB to lower the key refi rate from 0.25 per cent to 0.10 per cent and the deposit rate from zero percent to minus 0.15 per cent and justify this by means of a strong euro and a downward revision to inflation and growth projections," said Schubert.

"Furthermore, it is likely to try and tackle lending problems."

And here, it could pump liquidity into the financial system and attach conditions as to how it should be used, the expert suggested.

The ECB already made unlimited amounts of funding available to banks back at the end of 2011 and the beginning of 2012 via so-called long-term refinancing operations (LTROs).

But the banks did not lend it on to the small and medium-sized enterprises (SMEs) that form the backbone of the eurozone economy.

Hence, any further measures are likely to entail conditions, ECB watchers said.

If the ECB does take the deposit rate into negative territory, it would be the first major central bank to do so, effectively charging banks for parking their money with it.

It has so far refrained from doing so, in case the unprecedented move had unforeseen consequences.

"But it now appears to believe that a full lowering of the interest rate corridor would be most effective rather than just trimming the refi rate," said Archer at IHS.

Another measure could be so-called quantitative easing (QE), large-scale bond purchases as practised by other central banks such as the Bank of England and the US Federal Reserve.

But most ECB watchers believe this is unlikely for now.

The ECB's chief economist Peter Praet had said in May that this would only happen "if the economy and inflation develop significantly worse than we expect."

"Accordingly, the ECB seems unlikely to implement a full-blown QE programme at this stage," said McKeown at Capital Economics.

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