ECB seen cutting inflation outlook, hinting at more policy action

The European Central Bank is set to cut its inflation forecasts on Thursday but hold back from concrete policy action, promising only to beef up its bond-buying programme if growth and inflation prospects weaken further.

The bank, which left interest rates unchanged in a widely predicted decision, is expected to say the chances of missing its medium-term inflation target have increased due to lower oil prices, weaker growth in China and an appreciating euro.

But it is also likely to argue that its 1 trillion euro-plus asset-buying programme is working, albeit slowly, and that the time is not yet right to take further policy action, even though it has the power to expand purchases.

During his 1230 GMT news conference, ECB President Mario Draghi is expected to announce new GDP and inflation forecasts and discuss issues including China's economic slowdown, asset purchases and the ECB's second cut in Emergency Liquidity Assistance (ELA) to Greece.

The ECB launched its 60 billion euro ($68 billion) per month quantitative easing programme in March to boost consumer prices after a short bout of deflation.

But nearly all key price drivers have been working against its efforts to bring inflation, now running at 0.2 percent, back to its target of just under 2 percent.

Oil prices are down 35 percent since May, iron ore is near an all-time low, the euro has unexpectedly firmed and Chinese growth, already a worry for the ECB in July, is slowing sharply.

One of the bank's favoured gauges of inflation expectations, the five-year, five-year euro zone breakeven forward, has fallen below 1.7 percent from 1.85 percent in July.

The International Monetary Fund argued on Thursday that the ECB should consider extending QE, citing a rise in downside risks to the global economy due to a combination of threats, including China's slowdown and rising market volatility.

'Willingness to act'

A majority of analysts polled by Reuters expect the bank to eventually extend or increase its asset purchases. Three quarters said the bank has simply run out of tools and that adjusting QE, scheduled to run until next September, is its only viable option.

"Even if it appears too early to expect them to announce additional quantitative easing, central bank President Draghi should consider a more dovish rhetoric in order to prevent inflation expectations from falling further," Credit Agricole said in a note to clients.

Peter Praet, the bank's chief economist, has said markets should not doubt the ECB's "willingness and ability" to act. But comments from other rate setters like Benoit Coeure and Vice President Vitor Constancio suggest the bank will want to take time before taking action and prefers steady policy for now.

The ECB will also argue that the drop in oil prices will impact inflation only temporarily and that while near-term forecasts are cut more, the impact on 2017 inflation, earlier seen at 1.8 percent, will be more limited.

"Given the increasing uncertainty surrounding China, the ECB's wait-and-see mode will likely be characterized by heightened alertness to external events," UniCredit said.

"We expect ECB President Mario Draghi to respond to this more challenging environment with a strong commitment to further easing if price stability were to appear threatened."

EU Financial Affairs Commissioner Pierre Moscovici played down the risks, predicting in an interview with Italian newspaper La Stampa that growth would become more robust.

"We have seen how monetary authorities, above all in China, have reacted well and have the tools to continue to do so," he said in the interview, published on Thursday.

"In such a context we can benefit from low energy prices, growth-friendly interest rates, while reform efforts by European governments are bearing fruit and create better conditions for growth."

The ECB will also be keen to highlight some of the positive impacts of QE, even as inflation has stayed below 2 percent since early 2013.

Lending to eurozone firms in July grew at the fastest pace since early 2012, unemployment fell and the composite purchasing manager's index unexpectedly rose, offering a glimmer of hope that growth may be picking up after a lacklustre second quarter.

The bank may also argue that the impact of China's market volatility on the eurozone is limited and that the modest rise in yields on the euro zone's periphery amid a wider rout shows the bloc is in better economic health than at any time in years.

[Reuters]