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ECB to hold rates, forecasts awaited

Tuesday, December 03 14:55:50

The European Central Bank is likely to hold off any fresh policy action this Thursday, but new staff forecasts will be in focus for signs of prolonged price weakness that could lead it to act again next year.

After surprising markets last month with a cut in rates to a new record low, ECB President Mario Draghi said the euro zone "may experience a prolonged period of low inflation" and that the ECB was ready to consider using all available policy tools.

This month's ECB staff projections would give a fuller picture of how long that prolonged period would last, he said.

With inflation running far below the ECB's target of just under 2 percent, analysts are looking to the new projections for clues about whether the ECB could yet take further policy measures to support the euro zone's weak economic recovery.

Should the new projections point to inflation still clearly undershooting the ECB's target in 2015 - analysts expect a forecast of 1.3 or 1.4 percent - expectations will grow that the bank will take fresh action early next year.

"The tone is likely to be very dovish and the door for more action will be kept wide open," saying this could include negative deposit rates, more cheap long-term loans to banks (LTROs) or asset-buying quantitative easing (QE).

"There is simply no reason for the ECB to deny any possibilities."

In a Reuters poll, only one of 68 economists expected another cut at the Dec. 5 meeting.

Economic data since the November cut has been mixed.

On the positive side, inflation has quickened slightly - to 0.9 percent from just 0.7 percent in October, easing fears of deflation - and unemployment fell in October for the first time in almost three years.

However, lending remains weak, making it far too early for the ECB to sound the all-clear. A mention of widespread supply constraints in bank lending would be seen as a signal of the ECB planning action to free up credit.

Last month's cut took the ECB's main interest rate down to just 0.25 percent. To ease policy further, it would need to go beyond traditional measures - a move ECB hawks would resist.

"All further steps are unorthodox and it will be clearly more difficult for the Council to agree on them," UBS economist Reinhard Cluse said.

Perhaps the easiest policy for the central bank to agree would be adding liquidity by either scrapping reserve requirements, which would add about 100 billion euros ($135.57 billion) to the financial system immediately, or ending sterilisation of its earlier bond purchases.

Sterilisation involves offsetting the money used to buy bonds to keep money levels neutral. The ECB holds 184 billion euros of government bonds from its Securities Markets Programme (SMP), and takes a similar amount in weekly deposits from banks to offset the increase in the monetary base.

These steps could put downward pressure on short-term market rates. Despite November's cut, overnight market rates were mainly higher last month than earlier this year.

A new LTRO would be a further option to add funds to the market, but Vice President Vitor Constancio poured cold water on that idea last week, saying banks' liquidity position had improved.

In the run-up to Thursday's meeting, several senior ECB policymakers have also played down the prospect of the bank embarking on either of the two "nuclear" policies it has - U.S.-style quantitative easing, or negative interest rates.

The latter involves charging banks to deposit as a way to encourage the money to be lent out.

The ECB faces resistance to further easing in Germany, where inflation fears are deep-seated and central bank activism remains a taboo.

"The most powerful tool they have is obviously asset purchases," said Rabobank economist Elwin de Groot said, "but it is difficult to find support for it and it could even ignite a political crisis." (Reuters)