Fighting stubbornly low inflation, the European Central Bank is expected to ease policy further on Thursday, delivering a cocktail of measures that could include a deposit rate cut and changes to its asset-buying program.
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Promising to do what it must to boost inflation "as quickly as possible," the bank has all but committed to action, leaving investors guessing only what measures it would pick from an exceptionally long and sometimes contentious list.
Proposals under discussion range from mainstream moves like extending quantitative easing and cutting rates deeper into negative territory, to more extreme ideas, like a two-tier deposit rate that would punish banks for parking too much cash with the central bank instead of lending the money to generate growth and thus inflation.
"We stand on the brink of another extraordinary central bank policy easing today, from the ECB of course, which has been increasingly priced into markets, meaning amongst other things that you have to pay heavily indebted governments even more for the right to lend to them at the front end of the curve," Deutsche Bank said.
However, most of those proposals will run into some opposition on the consensus-seeking ECB Governing Council, making it more difficult for President Mario Draghi to extend his track record of promising big and delivering even more.
Critics of easing, led by the Governing Council's two German members, say that Europe's recovery is gaining strength and the biggest reason inflation is hovering near zero is the fall in oil prices, which is a boost for growth as lower energy costs leave households with more to spend.
The U.S. Federal Reserve's expected interest rate hike this month also complicates the decision. Fed Chair Janet Yellen said on Wednesday she was "looking forward" to a U.S. interest rate rise but an unexpectedly weak manufacturing survey this week has also raised fresh doubts about the Fed's rate path.
Still, top ECB officials, including chief economist Peter Praet, have focused their efforts on inflation, warning that missing the target again risked damaging the ECB's credibility and making monetary policy less effective.
The bank will lower its 2017 inflation forecast to 1.6 percent on Thursday, Bloomberg reported, in line with market expectations but below the ECB's target of close to but below 2 percent. That would be the bank's second straight cut in the inflation outlook and supports calls for more easing.
Even if oil prices account for part of the problem, core figures, which strip out energy prices, are running at half of the target, an indication that once the one-off effect of the crude price fall passes through, inflation will not rebound, they argue.
The ECB will announce its interest rate decision at 1245 GMT and Draghi will unveil new economic forecasts along with measures not involving rates at a 1330 GMT news conference.
The euro has weakened nearly 7 percent against the dollar since the ECB's last rate meeting in October, indicating that a policy move has been priced in, but also highlighting the risk of volatility in case the ECB disappoints.
SAVE SOME AMMUNITION
While the ECB does not target the exchange rate, it may need to act to preserve the euro's recent weakness against the dollar and the pound after recent falls lifted long-term inflation expectations to their best level since mid-year.
"The main reason why the ECB sees a need to signal more easing, even though it is not even halfway through its ongoing quantitative easing program, is that it wishes to prevent euro appreciation," SEB said in a note.
"A weak currency has been one important driving force behind the recovery, and with a hesitant Bank of England postponing its rate hikes ever further into the future, a euro rebound is a threat," it added.
Learning from its past mistake of providing overly specific forward guidance, the bank could extend its asset purchases indefinitely, only dropping the end date without providing a new one, and could cut the deposit rate, again without providing an estimate for where the bottom is for rates.
German banks would be the most affected by a cut in the deposit rate as they have nearly 160 billion euros ($169 bln) of excess cash parked at ECB or the Bundesbank, according to Barclays Research estimates.
The French and Dutch banking sectors each sit on more than 100 billion euros of excess cash, compared to less than 20 billion euros each for their peers in Ireland, Spain and Italy, the estimates show.
The improved economic outlook means the ECB can also afford to save some firepower for later, especially after promising data, including lending growth at a four-year high.
"In our view, the ECB should keep some of its tricks up its sleeves and stick to a small 10 basis point cut in December, and keep (schemes such as a two-tier deposit rate) in case of a further deterioration of the inflation outlook," Credit Agricole said.
"If the ECB wants to exceed market expectations, it could simply swing to a clear QE-infinity, and drop any time reference," it added.
(Editing by Susan Fenton)