Reuters

(Reuters)

ECB Takes Cautious Stance as Markets Tumble

Economic Indicators Reuters

The European Central Bank held interest rates at record lows on Thursday, but the market crash, tumbling bank stocks and ebbing inflation may set the stage for action later in the year.

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In December, the Governing Council cut the deposit rate, increased the charge on banks for parking money at the ECB, and expanded its purchase programme to buy chiefly government bonds.

This recent action, albeit short of what many on financial markets hoped for, meant that economists had expected the Thursday move and now shift their attention to possible action later in the year.

ECB President Mario Draghi, who holds his news conference at 1330 GMT, may address the threat of low inflation, as oil plunges, as well as the market ructions caused in part by weaker Chinese growth.

Draghi may also face questions about falls in the price of shares and bonds of several banks, particularly in southern European countries such as Italy. The cost of insuring against a default of many of these banks has risen sharply in recent weeks amid fears over unpaid loans, signalling bleak times ahead.

Having raised expectations too high in December, however, Draghi is likely to stop short of making concrete promises, emphasizing instead the central bank's readiness and ability to act.

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"The ECB is on hold for now," said Reinhard Cluse, an economist with UBS. "Draghi can say: 'we gave the medicine and now we have to let it work'".

Joerg Kraemer, an economist with Commerzbank, predicted a further reduction in the deposit rate in March.

A cut to its forecast for inflation then, which the ECB has pledged to keep at close to 2 percent, could prompt action.

The ECB's December projections were based on crude oil prices averaging $52.2 this year, but Brent crude is trading around $27 per barrel and even 2022 oil futures are below $50, indicating little confidence in a quick rebound.

CREDIBILITY

Some ECB policymakers have argued that it should focus on core inflation, which excludes energy and food.

But low energy prices are now impacting other goods and services, pushing even core inflation far from the bank's goal of close to 2 percent and jeopardising the credibility of that target.

"There is a risk that the world at large stops believing that the ECB will deliver on its target," ABN Amro economist Nick Kounis said. If that happened, "very low inflation could become entrenched."

The ECB earlier estimated that a 10 percentage point change in oil prices would change headline inflation by about 0.2-0.3 percentage point in the first year, with a further, second-round effect coming later.

Once companies stop believing in the inflation target, they might also curb wages, in turn putting a brake on the economy.

Draghi will emphasise that the bank's 1.5 trillion euro ($1.6 trillion) quantitative easing programme has flexibility, giving the bank plenty of room to act.

Records of the bank's December rate meeting also indicated a greater willingness on the part of policy makers to cut the deposit rate further. Many analysts predict that rate - which at -0.3 percent already charges commercial banks to park cash at the ECB - could drop by another 10 basis points as soon as June.

"(That) remains the low-hanging fruit and is priced by the third quarter," Deutsche Bank said.

Draghi's view on the global outlook could change given China's difficulties. In December, policymakers argued that earlier concerns about developments in China had not been borne out.

But stock market turmoil there since the start of 2016, a falling yuan and the weakest full-year growth figure in a quarter century suggest the risks have in fact increased.

An even weaker yuan would export China's deflationary risk and reduce the effectiveness of any rate cuts by limiting the ECB's ability to weaken the euro.

Weakness in China could also persuade the U.S. Federal Reserve to slow its rate increases, also putting the euro under firming pressure.

(Additional reporting by Balazs Koranyi and Frank Siebelt Editing by Jeremy Gaunt)