ECB to hold course as euro strength challenges recovery

FRANKFURT Wed May 7, 2014 6:07pm EDT

The new headquarters of the European Central Bank (ECB) is seen during a guided media tour in Frankfurt, April 29, 2014. REUTERS/Ralph Orlowski

The new headquarters of the European Central Bank (ECB) is seen during a guided media tour in Frankfurt, April 29, 2014.

Credit: Reuters/Ralph Orlowski

FRANKFURT (Reuters) - The European Central Bank is expected to take heart from signs of life in the euro zone economy and keep interest rates on hold on Thursday, resisting pressure to act in the face of a stronger euro and persistently low inflation.

Days before the Governing Council gathered in Brussels for its May policy meeting, France's Prime Minister Manuel Valls and the Organization for Economic Cooperation and Development called for more stimulus as the euro marched towards a 2-1/2 year high.

But while the ECB is expected to reiterate its concern about the impact the strong currency has on already-low inflation, it is not expected to act, at least not for now, as data points to a firmer recovery and improved financing conditions.

"We expect nothing," said BlackRock portfolio manager Lutz-Peter Wilke, whose multi-asset team has around $30 billion under management. "We don't think there will be a cut in rates, we don't think there will be further additional measures."

"The impact of the exchange rate will be the most interesting topic of the news conference," he said, hoping to get a sense for the ECB's pain threshold on the exchange rate.

A Reuters poll of more than 60 foreign exchange strategists said the euro would need to reach $1.42 to spur policy action. It was at $1.39 on Wednesday.

All but two in another Reuters poll of 63 economists expect the ECB to hold interest rates at a record low of 0.25 percent but roughly half of forecasters expect some form of stimulus in the future, be it a rate cut or asset purchases. <ECB/REFI>

Attention is shifting to the June meeting, when the ECB is due to update its staff forecasts for inflation. Many economists expect a downward revision after lower than expected readings in March and April, which could set the stage for more stimulus.

ECB President Mario Draghi has several policy tools at his disposal, including cutting rates or injecting more liquidity.

But the impact of such measures on the exchange rate and inflation is seen as being limited. For more impact, the ECB would need to turn on its money printing press, which is more a complicated option and not expected to happen any time soon.

Draghi said in April that if the inflation outlook were to deteriorate, the ECB could respond with a "broad-based asset purchase program", probably quantitative easing (QE) - effectively printing money to buy assets.

Last week, however, he told German lawmakers at a closed-door event that while low inflation would persist in the euro zone, he did not expect deflation, a source who attended the meeting said, adding that Draghi "made clear that we're still some way off QE".

WAIT AND SEE

The economy is showing increasing signs of stabilization.

Demand for home and corporate loans is expected to pick up, an ECB survey showed, while polls of euro zone business indicated on Tuesday they had a solid start to the second quarter.

Inflation rose to 0.7 percent in April, up from 0.5 percent in March, but still below expectations. Forty of 52 economists in a Reuters poll said euro zone inflation will not revisit the 0.5 percent or go any lower in the near future.

The bullish euro zone data helped boost the euro to its $1.39 level, near the 2-1/2 year high hit in March, also because of the economic weakness in the United States.

The ECB's talk about possible asset purchases also helped.

"Contrary to earlier expectations, recent dovish rhetoric may have contributed to euro strength by attracting significant capital inflows into the euro zone," BlackRock's Wilke said.

Italian, Spanish and Irish bond yields have hit record lows.

Euro zone companies, on the other hand, are feeling the pinch with French tire maker Michelin (MICP.PA), cement maker Lafarge (LAFP.PA) and Germany's Linde (LING.DE) saying they have been hit by foreign exchange headwinds in the first quarter.

In its assessment, the ECB looks at whether the stronger euro drives inflation lower and potentially threatens the recovery or whether the rise is driven by returning confidence and increasing capital inflows that lead to looser financing conditions that stimulate demand over time.

(Editing by Jeremy Gaunt)

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