Draghi vows to take action if outlook for inflation worsens

European Central Bank president Mario Draghi said today the bank will take action if the outlook for inflation worsens or money-market turbulence resumes.

He was speaking after Frankfurt left interest rates unchanged at 0.25 per cent, holding off policy action while it waits for new economic forecasts next month to assess the deflation threat facing the euro zone.

A sharp drop in euro zone inflation to 0.7 per cent in January, well below the

ECB’s target of just under 2 per cent, has put pressure on the ECB to act..

“We remain firmly determined to maintain the high degree of monetary accommodation and to take further decisive action if required,” Mr Draghi said at a press conference in Frankfurt, after the ECB’s monthly meeting.

“We firmly reiterate our forward guidance. We continue to expect the key ECB interest rates to remain at present or lower levels.”

Mr Draghi’s opening statement made no mention of any further stimulus measures at the current time.

Mr Draghi is trying to guide the euro area through a fragile recovery and an extensive health check of the banking system while ensuring he still has the policy tools to react to any worsening of the economic outlook.

He is also trying to negotiate the market swings sparked by the Federal Reserve’s decision to start exiting its own emergency stimulus policy.

Mr Draghi said the ECB was keeping an eye on risks stemming from volatility in emerging markets.

“The reasons for this situation in the emerging market economies are quite complex and are outside the control of the euro area policy authorities,” he said.

Furthermore, the bloc had so far shown “a good deal of resilience” to developments in those markets, he said.

Signs of slowing growth in China and the withdrawal of US monetary stimulus have sparked a sell-off in emerging markets, prompting abrupt interest rate rises in current account deficit countries such as India, South Africa and Turkey.

Money market traders had expected no change in rates, nor any other steps to combat falling inflation or prop up the euro zone, a poll taken on Monday showed. The ECB is wary of inflation getting stuck in what ECB president Mario Draghi has dubbed a “danger zone” below 1 per cent. The bank has vowed to keep rates at present or lower levels for an “extended period”.

The governing council met against the backdrop of turmoil in emerging markets which risks forcing the euro higher - a scenario that could put more downward pressure on prices.

The emerging market ructions and January’s inflation drop throw next month’s ECB staff projections into sharp relief - a downward revision could prompt policy action.

But first, markets will focus on Mr Draghi’s news conference. “Draghi will now have to deliver some very soft words to meet the market’s expectations,” said Anders Svendsen, chief analyst at Nordea.

A month ago, Mr Draghi set out markers for further ECB action, pledging the central bank would take action if its inflation outlook worsened or money markets saw “unwarranted” tightening.

But the ECB does not have a lot of ammunition left to boost inflation, which may make it reluctant to act too quickly. There might be only one more rate cut in its arsenal and even that would be smaller than the traditional quarter point.

For now, economic recovery is intact, though still in its infancy. The euro zone's private sector logged its busiest month in two-and-a-half years in January, with Germany leading the upswing, surveys showed yesterday.

The euro exchange rate has remained tolerable and is near two-month lows both against the US dollar and on a trade-weighted basis.

Besides low inflation and emerging market turmoil, short-term interest rate volatility has been another headache for the

ECB. To prevent spikes in market rates, the bank could choose to end offsetting government bond purchases made under its SMP programme, which would immediately add about 175 billion euros ($236.82 billion) to the money markets. “The market will be on alert for any measures announced at the press conference, particularly given heightened speculation on the future of the sterilization of the SMP, though we don’t expect this to be announced today,” said Matthews at Nomura. “The market will also be listening closely for any hints as to the likelihood of further action next month, and if so what form it could take.” A further complication is that by refraining from action, the

ECB risks making it more difficult to convince markets of its easing bias and keep the euro from shooting up. "To reel out the same lines with no action, that would not be very welcome," ABN Amro economist Nick Kounis said. "Financial markets have become numb to this kind of talk."Reuters