ECB to turn stimulus taps back on as economy slows
FRANKFURT (Reuters) - The European Central Bank is set to unveil fresh stimulus measures on Thursday to prop up the ailing euro zone economy, but its exact moves are far from certain and a decision that underwhelms markets risks pushing up borrowing costs.
With other major central banks easing monetary policy, Germany at risk of recession and inflation expectations sliding, ECB President Mario Draghi has all but promised more support, putting all of the bank's remaining tools in play.
But Draghi, who hands over the leadership of the central bank to Christine Lagarde at the end of October, will face resistance from more conservative members of the ECB's Governing Council.
Some policymakers have voiced concerted, public opposition to more radical stimulus measures, particularly the restarting of bond purchases, known as quantitative easing or QE.
There is also the risk that Draghi's dovish talk has raised investors' expectations so high that it will be difficult to fully deliver, leaving them disappointed. That could see market interest rates and the euro's exchange rate increase, rather than fall.
"There is high uncertainty about the extent of the expansionary measures the ECB will implement today; and therefore there is large potential for strong fluctuations in the euro exchange rates," Commerzbank strategists wrote in a note to clients.
Hours before the announcement, the weakness of the economy was evident in data that showed euro zone industrial production falling for the second month in a row in July. Germany's Ifo institute meanwhile predicted a recession would hit Europe's largest economy in the third quarter.
The single currency <EUR=> has fallen 3.5% against the dollar since the ECB began signaling an easing of its monetary policy in June, while yields on many euro zone government bonds have set new record lows.
While the ECB has a wide range of policy instruments at its disposal, each comes with complications, from questionable efficacy to big side effects.
The euro zone's biggest troubles -- a global trade war, Brexit and China's slowdown -- are also outside the central bank's control, suggesting any stimulus would have a limited impact.
The ECB is expected to lower some of its growth and inflation projections, highlighting that broader risks to the economy have risen since its last staff forecasts in June.
Sources told Reuters that the forecasts would predict growth of not much more than 1 percent both this year and next, with underlying and headline inflation rising only modestly.
The central bank aims for euro zone inflation of just below 2%, a target it has not hit since 2013.
'REINFORCED' POLICY GUIDANCE
A cut in the ECB's minus 0.4% deposit rate -- already a record low -- appears to be the least contentious move and policymakers will debate a 10 or 20 basis point reduction.
Although this would lower short term corporate borrowing costs, it would immediately hit bank profits as negative rates essentially amount to a penalty charge on their more than 1 trillion euros worth of excess reserves.
So the ECB is likely to exempt banks from part of this charge by introducing a multi-tier deposit rate.
While this option would give an immediate boost to banks, critics argue it would only be small and would disproportionately benefit lenders in France and Germany.
The ECB is also expected to push out the timing of any rate hike even further, providing a "reinforced" guidance on rates that would tie any move to certain inflation conditions, lowering the emphasis on calendar dates.
The ECB announces its rate decision at 1145 GMT, followed by Draghi's news conference at 1230 GMT.
The most contentious part of the package will be whether to restart bond purchases.
Although this is the ECB's most powerful weapon, over half a dozen policymakers, including the central bank chiefs of Germany, France, the Netherlands and Austria have expressed scepticism about the need for it.
They argue the bloc is experiencing a slowdown, not a recession, and that such a tool should be reserved for real crises, especially since the ECB has already used up much of its firepower in past rounds of stimulus.
Indeed, rates are at record lows and the ECB's balance sheet is more than a third bigger than the U.S. Federal Reserve's, indicating limited room for more action.
But with the Fed cutting rates last month and sending some dovish signals about future policy, the ECB can hardly avoid keeping pace to stop the euro appreciating and further dampening inflation.
"While we don't see much room for the ECB to disappoint on rate cuts, forward guidance and tiering, we think the Governing Council may be less dovish than what is priced in by delivering a less generous asset purchase program," Nomura said.
Draghi is still likely to have the votes if he wants to go ahead with bond purchases, but opposition from the bloc's biggest economies could be damaging to the ECB's authority.
Possible compromises include approving a relatively small bond purchase scheme without changing previously established purchase limits, to avoid stirring up a legally contentious issue.
Another issue is that with Draghi leaving on Oct. 31, some policymakers appear less keen to make a long-term commitment that would tie the hands of the bank's next president.
"A compromise solution could be to announce QE but to leave the details until later. This would buy more time for the ECB Governing Council to reach a consensus and allow incoming President Christine Lagarde to "own" the program," BNP Paribas economist Luigi Speranza said.
(Reporting by Balazs Koranyi; Editing by Toby Chopra and Catherine Evans)
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