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ECB to drive policy further into uncharted territory

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 programme.

[FRANKFURT] 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 programme.

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, to more extreme ideas, like a two-tier deposit rate that would punish banks parking too much cash with the central bank instead of lending the money to generate growth and thus inflation.

But 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.

Indeed, business activity in the euro zone picked up at its fastest pace since mid-2011 last month, third quarter economic growth was running at a respectable 1.6 per cent and lending is increasing at the quickest rate in four years.

The US Federal Reserve's expected interest rate hike also complicates the decision. While a December move has been widely telegraphed, an unexpectedly weak manufacturing survey this week raised fresh doubts about the Fed's rate path.

But 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.

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.

Indeed, analysts polled by Reuters expect the ECB to cut its 2017 inflation forecasts to 1.6 per cent from 1.7 per cent, below its target of close to but below 2 per cent, indicating that the inflation could be below target for over 4 years.

The ECB will announce its interest rate decision at 1245 GMT and Mr Draghi will unveil new economic forecasts along with measures not involving rates at a 1330 GMT news conference.


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 programme, 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 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.