Deflation fears in spotlight as ECB meets

Analysts expect the European Central Bank to hold its key rates steady at its policy meeting Thursday, but a threat of deflation in Europe could force the bank's hand soon. The annual rate of inflation for the 17 countries that share the euro slowed unexpectedly to just 0.7 percent in October, the lowest rate in four years, raising fears the single currency area may tip into deflation -- a vicious circle of falling prices, wages and output. But ECB watchers are not convinced that the data will trigger action from the central bank just yet. With eurozone interest rates currently at an all-time low of 0.50 percent, "the ECB has only one bullet left in its conventional tool box, and as long as the economy proceeds in line with expectations, the central bank may be reluctant to respond to lower inflation with a rate cut," said UniCredit economist Marco Valli. ING DiBa economist Carsten Brzeski agreed. The rate-cut speculation "is premature," he said. "The ECB simply does not have a reputation for knee-jerk reaction to single data releases. And a rate cut would do little to kick-start the economy as long as the transmission mechanism is not working properly," Brzeski argued. "Even if deflationary trends have opened the door wider for further ECB easing, we don't expect such action this week." Any further rate cut would only be seen "in the coming months, if and when deflationary tendencies prevail," the expert concluded. Deflation is bad for the economy because it can lead consumers to delay purchases in the expectation that prices will fall. Slower sales have a knock-on effect on orders to factories, which reduce production and then either cut wages or jobs. This leaves households in an even worse position and then often fearful to spend, worsening the cycle even further and creating a vicious circle that feeds upon itself. The euro's recent strong rise against the dollar and other major currencies is another headache for the ECB while the green shoots of economic recovery in the 17 countries that share the euro remain very vulnerable. A strengthening euro makes the region's exports more expensive and would therefore choke off foreign demand for European goods. It also feeds deflation. "The most effective measure that the ECB could take to diminish the risk of deflation would be to talk the euro down," said Marie Diron at EY Eurozone Forecast. "We think that the euro is currently overvalued and the ECB expressing similar concerns could potentially push the currency down," she said. As well as easing deflationary fears, "this would have the benefit of boosting the region's competitiveness and growth," she added. The euro has in fact actually come down from its recent highs of $1.38 as the lower-than-expected inflation fuelled rate cut speculation. That "buys some time for the ECB" on rates, said Valli at UniCredit. But Brzeski at ING DiBa warned that "in the absence of concrete action (by the ECB), the euro could reverse its latest losses, re-entering the ECB's danger zone. "Therefore, we expect the ECB to tackle the exchange rate verbally by including it as a downside risk to both inflation and growth," Brzeski said. Another possible avenue of action would be for the ECB to pump more liquidity into the markets in the form of more long-term refinancing operations (LTROs), which it used at the end of 2011 and the beginning of 2012 to avert a possible credit crunch. Draghi specifically raised such a possibility at the ECB meeting last month. But some ECB council members -- notably executive board member Benoit Coeure and German central bank chief Jens Weidmann -- harboured reservations about such a move, Kraemer noted. And analysts agreed a move was unlikely to come as early as this week. "We think that the ECB's next move will be another LTRO, possibly a very long one of up to five years, conditional to new lending to firms and households. That will probably come in the first quarter of 2014," said UniCredit's Valli.