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ECB holds rates, seen charting course to more easing in December

[October 20, 2016] By Francesco Canepa and Balazs Koranyi

FRANKFURT (Reuters) - The European Central Bank kept interest rates and policy guidance unchanged on Thursday but may lay the groundwork for more easing to come in December as it tries to sustain a long-awaited rebound in consumer prices.

Holding interest rates deep in negative territory and maintaining bond purchases at 80 billion euros per month, ECB President Mario Draghi is likely to emphasize later at a news conference the continued need for monetary stimulus, reinforcing expectations for an extension of the ECB's asset buys beyond its scheduled end next March.

The ECB has provided unprecedented stimulus for years with sub-zero rates, free loans to banks and over a trillion euros in bond purchases, all in the hope of reviving growth and lifting inflation back to its target of just below 2 percent after more than three years of misses.

In a widely expected decision on Thursday, Draghi kept the deposit rate at minus 0.4 percent and maintained the ECB's guidance for rates to stay at their current or lower levels for an extended period. Attention now turns to the news conference at 1230 GMT (0830 EDT), with markets looking for fresh hints about its expected move in December.

The trick for Draghi will be to keep the door firmly open to more stimulus without any hint of commitment that could rattle markets and lead to a repeat of turbulence set off last year, when the ECB raised expectations too high and did not fully deliver on them.

Action is far from urgent, however. The euro zone economy is chugging along, inflation is at a two-year high, national budget proposals suggest a bit more fiscal support, and the early impact on euro zone economies of Britain's decision to leave the European Union has been muted. All these suggest that the 19-country bloc is on the path predicted by the ECB in September.

But Draghi and fellow board members have gone to pains in recent weeks to emphasize that this outlook is predicated on "very substantial" monetary support, a hint taken as confirmation that an extension is coming.

Indeed, ECB chief economist Peter Praet has warned that a premature withdrawal of stimulus would stall and reverse the upswing, a further sign any tapering is well into the future.

"Present loose (financial) conditions also reflect expectations of additional ECB action, this suggests that the ECB will have to do more just to preserve the current degree of accommodation," UniCredit economist Marco Valli said prior to the rate decision.

"Therefore, anything less than quantitative easing extension at 80 billion euros per month risks tightening financial conditions via higher yields, a stronger currency and, possibly, lower risk appetite."

The ECB's 1.74 trillion euro quantitative easing (QE) scheme is now set to expire in March but the bank has always said that it would run until it saw a sustained recovery in inflation.

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The headquarters of the European Central Bank (ECB) are pictured in Frankfurt, Germany, September 8, 2016. REUTERS/Ralph Orlowski/File Photo

Analysts polled by Reuters unanimously expect unchanged rates with the vast majority predicting a three to six month extension to asset buys in December.

WEAK INFLATION

The root of the problem is that inflation is still too weak and may not hit the target for another 2-3 years at the earliest.

Though it rose to 0.4 percent last month and may exceed 1 percent by the spring, the rise is due almost entirely to the fading impact of a drop in oil prices and not a rebound in underlying prices.

Wage growth meanwhile remains weak, core inflation is stuck below 1 percent and unemployment is high, suggesting that the rise is far from the sustained increase the ECB had hoped for.

Lending growth is also showings signs of leveling off, suggesting that banks may be struggling to pass on some of the ECB's ultra loose policy measures.

Indeed, policymakers are increasingly emphasizing the negative side effects of sub zero rates, particularly for banks, suggesting that another rate cut may not be among the options to be discussed in December.

The ECB relies on banks to transmit its policy measures but low rates are hurting margins and depressing share prices, likely leading to a curb on lending.

Any meaningful extension of asset buys will however require the ECB to modify some of the program's technical constraints to counter the scarcity of some assets, like German bonds.

Those changes could include relaxing some of the ECB's self-imposed constraints, like the rule prohibiting the bank to buy assets yielding less than its deposit rate or the rule requiring it to buy assets in proportion to each country's shareholding in the ECB.

(Editing by Jeremy Gaunt)

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