LDN - Business

ECB keeps policy unchanged, faces questions over euro surge

[January 25, 2018] By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) - The European Central Bank kept its ultra-easy policy firmly on hold on Thursday but ECB chief Mario Draghi will now face the difficult task of addressing the euro's potentially damaging surge against the dollar.

Even as the euro zone economy roars ahead, a strong euro threatens to dampen inflation and endanger the work done by years of unprecedented stimulus, probably forcing Draghi to pour cold water on rising expectations that the ECB is speeding towards an interest rate hike.

His task was made even more delicate overnight when top U.S. officials made their case for a weak dollar, sending the greenback to a three year low against the euro and raising fears of renewed trade wars.

Still, in a widely expected decision, the ECB kept its key interest rate deep in negative territory, maintained a pledge to hold rates steady until well after bond buys conclude and promised to continue asset purchases until a sustained rebound in inflation.

"The Governing Council expects the key ECB interest rates to remain at their present levels for an extended period of time, and well past the horizon of the net asset purchases," the central bank said in a statement.

He is now set to address reporters in a 1330 GMT news conference where the euro's rise and expected changes in the bank's policy guidance will likely take center stage.

U.S. Treasury Secretary Steve Mnuchin said he welcomed a weak dollar, arguing that it was good for U.S. trade, and Commerce Secretary Wilbur Ross said “U.S. troops are now coming to the ramparts” in global trade wars.

Any discussion about the euro is likely to be a delicate balancing act: the euro's five and a half percent rise since December holds back inflation which the ECB wants to see climb. But rapid economic growth and the likely end of the bond buys later this year justify some currency strength.

Wanting to keep all options on the table, Draghi is likely to signal a concern about the rapid rise in the currency but will maintain that it is not a policy target, hoping to strike a balanced message until policymakers are ready to unveil their blueprint for winding down stimulus, economists said.

Having bought more than 2 trillion euros worth of bonds over the past three years, the ECB has almost single-handedly depressed borrowing costs in the euro zone to kick start growth and lift prices.

The purchases, already twice reduced, are set to run until the end of September and investors are betting on their end in the fourth quarter.

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European Central Bank (ECB) President Mario Draghi waits to address the European Parliament's Economic and Monetary Affairs Committee in Brussels, Belgium September 25, 2017. REUTERS/Francois Lenoir

But predictions for tighter ECB policy are adding to pressure on the currency and raising market bets for a rate hike as early as December, a move seen as premature even by the most hawkish of policymakers.

Inflation is also years away from rising back to the ECB's target of 2 percent, so Draghi can hardly afford any big currency swings.

MODEST IMPACT

While the euro's gain so far has only a modest impact on inflation, the worry is that weaker economies on the bloc's periphery would be affected by it more, a risk to an economic convergence process that restarted only recently.

Part of his holding pattern approach, Draghi also kept the bank's guidance unchanged, maintaining a promise to continue asset buys until a sustained rebound in inflation, even after policymakers agreed in December to begin work in early 2018 to draft a new guidance.

Policymakers argued that the ECB should give up a singular focus on asset buys in the guidance and should raise the role of interest rates in policy accommodation.

Such a move would also reinforce expectations that quantitative easing would likely end this year, barring any unexpected changes in growth and inflation.

But even a normally cautious Draghi is seen unlikely to shoot down these expectations and the economy is running out of spare capacity, the jobless rate is rapidly dropping and growth is now sustainable even with reduced central bank support.

Indeed, growth projections, revised up repeatedly, already look too pessimistic as manufacturing, trade and jobs data all point to superb run for the euro zone economy, economists argue.

"While it is by now widely recognized that euro area growth is strong, the extent of this is still being hugely underappreciated," JPMorgan economist Greg Fuzesi said before the rate decision.

(Reporting by Balazs Koranyi and Francesco Canepa Editing by Jeremy Gaunt)

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