WRAPUP 2-Draghi says a stronger euro would trigger looser ECB policy

Sat Apr 12, 2014 4:51pm EDT

(Adds comments from Draghi, Brazil, Japan; currency background)

* Clearest signal yet that exchange rate could bring QE

* ECB should mull action if inflation stays low - IMF nations

* Japan, Brazil among nations leaning on Europeans

By Jan Strupczewski and Krista Hughes

WASHINGTON, April 12 (Reuters) - The European Central Bank will ease monetary policy further if the euro keeps strengthening, President Mario Draghi said on Saturday as world finance chiefs ramped up pressure on Europe to ward off deflation.

In the clearest signal yet the ECB was prepared to launch a stimulative asset-purchase program, Draghi said the euro's exchange rate had become increasingly important to policy and would act as a trigger.

"The strengthening of the exchange rate would require further monetary policy accommodation. If you want policy to remain as accommodative as now, a further strengthening of the exchange rate would require further stimulus," he told a news conference.

The issue of weak euro zone inflation took center stage at meetings of top finance ministers and central bankers on Saturday, with the International Monetary Fund's steering committee urging the ECB to consider acting if low inflation became persistent.

"The Fund is recommending more monetary easing to the ECB, and rightly so," said Guido Mantega, Brazil's finance minister.

The world's financial markets are watching closely. Last week, the ECB kept interest rates steady but opened the door to turning on its money-printing presses to boost the weak euro zone economy and inflation. At that time, Draghi said the ECB had achieved unanimity that asset purchases, or so-called quantitative easing, might be needed.

Over the past 12 months, the euro has strengthened by nearly 5.5 percent against the dollar and by nearly 10 percent against the yen. In recent weeks, it has reached levels against the dollar not seen since late 2011. It ended last week at just below $1.39.

Draghi said on Saturday that euro appreciation over the last year was an important factor in bringing inflation in the currency bloc down to its current low levels, accounting for as much as a half percentage point of the decline in the annual rate, which stood at only 0.5 percent year-on-year in March. The ECB aims to keep inflation close to but under 2 percent.

"I have always said that the exchange rate is not a policy target, but it is important for price stability and growth," Draghi said. "What has happened over the last few months is that it has become more and more important for price stability."

The euro's recent strength has baffled many players in the global currency market given Europe's low interest rates, tepid growth prospects and near-zero inflation. In fact, most currency analysts expected an improving outlook for the U.S. economy and the winding down of the U.S. Federal Reserve's massive stimulus program to drive the dollar up against the euro this year.

Some of the investment flows supporting the euro are reflected in the strong performance of sovereign debt from several of southern Europe's bailed-out nations, which until recently had featured substantially higher yields. On Thursday, for instance, an auction for 3 billion euros of five-year bonds sold by Greece drew more than 20 billion euros in orders.

AN ORIENTATION, NOT A LEVEL

Quantitative easing was something previously considered highly undesirable by some euro zone central bankers, and only to be considered if prices were falling outright.

But policymakers in recent weeks publicly broached cutting deposit rates below zero - effectively charging banks that hold excess cash at the ECB - or embarking on bond purchases as have the United States, Japan and Britain, if the threat of deflation became more acute.

Draghi said two things would drive any decision: "One is an unwanted tightening of monetary financial conditions, and the second is deterioration of our medium term outlook."

"I don't want to give you a level where we will act or not. I am giving you an orientation," he said of euro strength.

In July 2008, the currency's rise to an all-time high of $1.60 did not trigger an ECB response, even though euro zone finance ministers tried to talk down the currency. But inflation was near an all-time high at 4 percent, serving the ECB's need to keep price growth in check.

JAPAN'S PAINFUL EXAMPLE

In a rare move for the usually soft-spoken Japanese, Finance Minister Taro Aso - drawing on Japan's own experience of a protracted period of deflation - directly warned the euro zone about the dangers of falling prices.

"Based on our experience, once a deflationary mindset takes hold, it is easy to fall into a vicious cycle, whereby people start to postpone consumption and investment, leading to further deflationary pressures," he told the IMF panel.

There are striking parallels between 1990s Japan and the euro zone's plight now: weak bank lending, fragile economic growth, a rising exchange rate, and the central bank's insistence that deflation is not on the horizon.

While Japan has been mired in deflation for most of the last 15 years, the price declines in the early years were so mild that the Bank of Japan was slow to acknowledge deflation had set in.

That is why Japanese policymakers warn against complacency even if, as Draghi points out, long-term inflation expectations in the euro area appear to remain "well-anchored." (Reporting by the Reuters IMF/World Bank team; Writing by Jonathan Spicer; Editing by Andrea Ricci and Dan Burns)

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