European Central Bank Leaves Key Rate Unchanged

The European Central Bank kept its main interest rate unchanged deep in negative territory on Thursday and stuck to its extraordinary stimulus policies aimed at reviving inflation and kick-starting growth after nearly a decade of economic malaise.

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Buying assets to the tune of 1.74 trillion euros ($1.94 trillion) and keeping rates negative, the ECB is trying to boost inflation, which has been stuck in negative territory for months, raising the risk the 19-member currency bloc sinks into a deflation spiral.

Still, with oil prices almost doubling since early January, ECB President Mario Draghi may nudge up the bank's inflation projections, breaking a damaging cycle of having to cut forecasts quarter after quarter, and supporting calls for patience with measures taken in December and March.

Indeed, corporate bond buys, announced three months ago, will only start on June 8, and the first allotment of ultra cheap loans is not due until later this month, keeping more stimulus in the pipeline and supporting an argument by some policymakers for the ECB to stay on the sidelines at least until autumn.

Investors' attention now turns to Draghi's 1230 GMT press conference, where he will unveil new growth and inflation forecasts, arguing that the bank's measures along with rising oil prices are finally reviving inflation, boosting lending and helping growth.

Draghi is also likely to provide more detail on the corporate bond buying plans and discuss how Greek banks could regain access to ordinary ECB funding after more than a year on an expensive emergency lifeline.

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"Although the expected (inflation forecast) adjustment is modest, it may help put a floor under inflation expectations and allow the ECB to remain in a wait-and-see mode while its latest measures work their way through the economy," UniCredit economist Marco Valli said. "The revision is likely to be entirely energy-driven."

The ECB will also maintain its guidance that rates will stay at their current or lower levels for an extended period but Draghi may repeat his view that he does not foresee another rate cut.

Indeed, the vast majority of analysts polled by Reuters see rates on hold at least until the end of this year, with markets having mostly priced out a further cut.

Inflation has missed the ECB's target of nearly 2 percent for years as high unemployment keeps a lid on wages, high debt levels choke investment, demand for goods and services remains weak and sharply lower oil prices drag down prices.

But with first quarter growth beating all expectations, economic sentiment rising, investments recording a surprising surge and household consumption holding up, the euro zone economy is on its best run since the global financial crisis.

Even if only few see the surge as sustainable, most economists expect growth to ease back just slightly, toward a path consistent with the ECB's expectation for modest but increasingly broad-based expansion.


Yet, the news regarding inflation is not all positive.

Higher oil prices may lift headline prices, but the underlying trend remains weak and the ECB may even cut its forecast for core inflation, which excluded food and fuel.

"The core inflation forecast will in our view be revised lower over the entire forecast horizon," Danske Bank economist Pernille Bomholdt Henneberg said.

"The ECB argues that core inflation will rise as the labor market improves, but we believe wage pressure will stay modest for some time due to labor market slack, while the stronger effective euro will also be a headwind."

Indeed, the euro zone five-year, five-year breakeven forward , a market-based long-term inflation projection, is hovering below 1.5 percent, indicating little market confidence the ECB can meet its target in the coming years.

Peter Praet, the ECB's chief economist, has also warned that inflation expectations may be de-anchoring, which would suggest euro zone companies and consumers are losing faith in the ECB's ability to raise inflation.

Any core inflation cut would not trigger fresh ECB measures on Thursday but raises the likelihood that the ECB will eventually extend its asset buying scheme, which is set to run at least until March 2017.

"Our expectation is that the QE program will be extended to the end of 2017 and we think that an announcement could be made in September," JPMorgan economist Greg Fuzesi said.

"The medium-term inflation forecast remains low-ish, which creates the risk of an unanchoring of inflation expectations," Fuzesi said. "Ending quantitative easing in March would also cause an unwanted tightening in financial conditions."

(Editing by Jeremy Gaunt and Hugh Lawson)