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ECB unexpectedly cuts asset buys, extends until end 2017

[December 08, 2016] By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) - The European Central Bank unexpectedly reduced its asset buys on Thursday but reserved the right to increase purchases once again, a decision that may be seen as a concession to conservative euro zone members such as Germany.

The ECB will reduce its asset buys to 60 billion euros from next April from the current 80 billion euros, maintaining the buys until the end of the year.

Markets had expected the purchases to stay at 80 billion but only for 6 more months, suggesting a compromise solution in the Governing Council.

"If, in the meantime, the outlook becomes less favorable or if financial conditions become inconsistent with further progress towards a sustained adjustment of the path of inflation, the Governing Council intends to increase the program in terms of size and/or duration," the ECB said.

The euro jumped to a three-week high after the announcement.

With high risk elections looming in four of the euro zone's five biggest economies, the ECB was fully expected to keep the asset buys going, likely fearing that cutting back prematurely could abort a still timid recovery and unravel the impact of its purchases.

But as much of its firepower is already exhausted and conservative member states, particularly Germany, grow increasingly frustrated with its unprecedented stimulus, the ECB was also pushed by some to cut back.

The ECB has already spent more than 1.4 trillion euros ($1.5 trillion) buying bonds and has been at pains in the past month to emphasize that maintaining easy financing conditions is 'crucial' as underlying inflation seems to be stuck below 1 percent.

"To ensure the continued smooth implementation of the Eurosystem’s asset purchases, the Governing Council decided to change some of the parameters of the(asset-purchase plan) which will be communicated at today’s press conference and in a separate press release," the ECB added.

Interest rates, seen by most to have bottomed out, were kept unchanged, with the deposit rate kept deep in negative territory. Markets attention now turn to Draghi's 1330 GMT news conference, where he will also unveil fresh economic forecasts.

On the face of it, the new projections are likely to be relatively upbeat. Inflation - which has been dangerously low - is now at its highest in more than two years and rising.

Higher oil prices and predictions for more U.S. budget spending are bolstering expectations and 2019 forecasts may show price growth finally hitting the ECB's target of almost 2 percent for the first time since early 2013.

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Euro zone economic growth is shrugging off Britain's decision to leave the European Union, and Germany, the bloc's growth engine, seems to be picking up speed again.

Ironically, the collapse of Italy's government this week may actually hasten instead of delay the recapitalization of ailing lender Monte dei Paschi <BMPS.MI>, much to the ECB's relief. It has pointed to weak banks as a key obstacle to transmitting stimulus.

Italian bank shares are up 13 percent this week, and the yield differentials between the sovereign bonds of Germany and peripheral countries like Italy and Spain have narrowed since Sunday's vote.

The euro <EUR=> hovered near a three-week high versus the dollar on Thursday and European shares rose for a fourth straight day.

WEAK OUTLOOK

But beneath the surface, the outlook is far from comforting.

The inflation rise is almost entirely due to past declines in oil price being knocked out of statistics. Underlying inflation is flat, if not slowing, suggesting that price growth is far from sustainable, a key condition for removing stimulus.

Wage growth has also disappointed, suggesting that companies have cut their inflation expectations. This is a hard-to-break cycle that could entrench anemic price growth, making it harder to get it back to the desired at-or-just-below 2 percent.

Even consumption, the key driver of growth is not as good as it looks. Consumption has been driven a jump in disposable income due to oil price falls and loose ECB policy. But Brent crude <LCOc1> is up 14 percent in the past three months, leaving monetary policy as the chief driver of consumption.

The rising clout of populist parties could also weaken governments' resolve to push ahead with painful but needed reforms. Elections in France, Germany, the Netherlands and possibly Italy could leave the ECB with more of the burden.

Even if many of the ECB's fresh economic forecasts will be broadly unchanged from three months ago, the projection for underlying inflation is likely to be cut, a sign that the rise in inflation may be temporary.

(Editing by Jeremy Gaunt)

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