ECB holds rate steady as focus on inflation, China

The European Central Bank held its key rates steady Thursday but may have to consider fresh policy measures soon to prevent deflation amid market alarm over the economic fallout from China, analysts said.

ECB president Mario Draghi was scheduled to explain the reasoning behind the decision at his traditional post-meeting press conference.

Central bank watchers expected him to leave the door open to further monetary easing given signs that eurozone inflation is still much lower than the ECB would like.

"The decision ... to leave its policy stance unchanged was widely expected, but Draghi is likely to give some dovish signals," said Capital Economics economist Jonathan Loynes.

"Admittedly, the latest news on the eurozone economy has been reasonably upbeat ... (and) the Greek crisis has clearly eased somewhat after the approval of the third bailout.

"Nonetheless, the growth outlook is hardly strong and the concerns over China and the appreciation of the euro present a serious external threat," the expert said.

Area-wide inflation was uncomfortably close to zero and could well drop below it again in coming months if oil prices remain at the current level, Loynes argued.

"Against that background, we suspect that Draghi will insist again that the ECB's current QE programme will be implemented in full and give a further strong hint that it might be extended or accelerated, or both. He won't say so, but part of the intention will no doubt be to weaken the euro again," the analyst said.

The International Monetary Fund on Wednesday insisted that global central banks must ensure that monetary conditions remain "accommodative to prevent real interest rates from rising prematurely."

And addressing the ECB directly, it said the QE programme had "improved confidence and financial conditions, and raised inflation expectations initially.

"More recently however, inflation expectations have reversed, and the euro has strengthened, which could put downward pressure on prices. Hence, the programme should be extended if there is not sufficient improvement in inflation consistent with meeting medium-term price stability objectives," it said.

- Return of deflation fears? -

Fears of deflation -- a dangerous spiral of falling prices -- persuaded the ECB to launch in March its controversial QE programme, under which it plans to purchase 60 billion euros ($68 billion) of sovereign bonds each month until September 2016, or 1.14 trillion euros in all.

Initially the scheme appeared to work, slowly pushing inflation back up in core eurozone economies such as France and Germany.

But euro-area inflation still stood at only 0.2 percent in August, way off the two percent level which the ECB regards as conducive to healthy economic growth. And that target may not be attainable until 2018.

Falling oil prices and signs of an economic slowdown in China spooked stock markets worldwide last week. And with the euro seen as a safe haven for investors, the strengthening single currency could undermine exporters' competitiveness and also exert downward pressure on inflation.

The ECB is scheduled to publish its updated growth and inflation forecasts for the 19 countries that share the euro on Thursday and central bank watchers expect the projections to be downgraded noticeably.

- No immediate action -

Deka Bank economist Kristian Toedtmann said that at the post-meeting press conference, Draghi "is likely to stress the downside risks. But the scenario he will paint will not yet be threatening enough to warrant immediate action."

Instead, Draghi was likely to underline the ECB's readiness to ease monetary conditions still further should the economic outlook deteriorate substantially, Toedtmann said.

ECB executive board member Benoit Coeure insisted recently that "we do not wake up every morning and look at the economic indicators in order to decide whether to raise or lower interest rates or whether to stop or expand QE. We have a medium-term perspective."

And he added: "We would only see ourselves forced to act if there was a fundamental change in the economic situation or the monetary stance was materially altered because of developments in the markets."

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