ECB stays on hold but Draghi likely to highlight growth risks

[July 26, 2018]   By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) - The European Central Bank kept its policy unchanged on Thursday and will likely argue that the risks from a growing global trade conflict don't warrant any deviation from its plan to gradually abandon the aggressive stimulus of the last several years.

The ECB said it still plans to wrap up its lavish bond purchases by the end of the year and sees interest rates at record lows through the summer of 2019, a guidance few if any investors had expected to change just six weeks after a complete policy revamp.

With inflation rebounding and employment at a record high, the ECB decided last month to end its 2.6 trillion euro ($3.0 trillion) bond buying scheme in December, taking its biggest step yet towards removing the stimulus credited with dragging the euro zone out of years of stagnation.

Still, with growth slowing and sentiment weighed down by an escalating trade war, the ECB had pushed out its rate hike expectations.

This suggested that it would wean the euro area off its stimulus by the smallest of increments, fearing that even a slight amount of turbulence could derail the recovery in inflation.

Attention now turns to ECB President Mario Draghi's 1230 GMT news conference, where he is unlikely to upset market expectations for a late 2019 rate hike and may argue that little has changed since the June meeting, even if growth indicators remain weak.

Indeed, the composite PMI indicator dipped in June, consumer confidence eased and the German IFO business climate index for July fell - all pointing to a persistent slowdown that could force the ECB in September to once again lower its growth projections.

But the pace of expansion is still above what is seen as the bloc's potential growth rate, so the ECB can argue that the euro zone will continue to create jobs and eventually generate inflation, the bank's ultimate aim. It targets price growth just below 2 percent.

A tentative deal between U.S. President Donald Trump and European Commission Chief Jean-Claude Juncker to return to the negotiating table instead of imposing new tariffs could also fuel some mild optimism.

Meeting on Wednesday, Trump agreed to refrain from imposing car tariffs, and the two sides said they would launch negotiations to cut other trade barriers, including U.S. tariffs on steel and aluminum and Europe's retaliatory duties.

The headquarters of the European Central Bank (ECB) and the Frankfurt skyline with its financial district are photographed on early evening in Frankfurt, Germany, March 25, 2018. REUTERS/Kai Pfaffenbach/File Photo

(For a graphic on 'ECB policy vs. inflation and bond yields' click https://reut.rs/2JPYo6Y)

Investors will also be keen to hear if the ECB discussed another tweak to its guidance or revising the rules on how it invests cash from maturing bonds.

In June, the ECB said it "anticipates" that bond buys will end in December, a phrasing that could be firmed up to signal increased confidence in the June decision.

Still, such a move is not seen as necessary because the markets have fully priced in the end of the bond buying this year, and the bar for another extension is seen as exceptionally high.

But Draghi is likely to avoid providing a more precise timing for the first rate hike, sticking with the ECB's wording for steady rates "through the summer" of 2019.

Money markets fully price in a 10-basis-point increase to the ECB's deposit rate, currently set at -0.40 percent, only in October 2019.

With fresh buying due to end this year, the reinvestment of cash from expiring bonds will become a more significant policy tool, and Draghi has said that updated rules on how to spend this cash are likely to come in the coming months.

A key challenge is that the remaining maturity of the bond pile declines over time, so the ECB will have to decide whether to target longer-dated bonds or to accept the natural aging of its portfolio.

Another option on the table may be to increase the ECB's flexibility in reinvestments as current rules on the timing of buys could tie the bank's hands too much, forcing it to make large purchases in a given market when smoother buys would be more appropriate.

(Editing by Hugh Lawson)

[© 2018 Thomson Reuters. All rights reserved.]

Copyright 2018 Reuters. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.  Thompson Reuters is solely responsible for this content.