UPDATE 2-ECB watching deflation risks and ready to act, says Draghi

Mon May 26, 2014 11:56am EDT

Related Topics

* Draghi says ECB must watch for negative price spiral

* May need pre-emptive action if inflation expectations drop

* Ready to use conventional measures; asset-buy plan also an option

* Sees "bridging role" for ECB if banks lack funds to lend

* Experts regard ABS plan as tricky to implement (Adds Reuters poll, comment from experts at ECB forum)

By Eva Taylor

SINTRA, Portugal, May 26 (Reuters) - The European Central Bank must be "particularly watchful" for any negative price spiral in the euro zone, ECB chief Mario Draghi said on Monday, adding that the bank was not resigned to inflation being too low for too long.

The ECB is on guard against deflation and ready to act with conventional and targeted measures, Draghi said, and a broad asset-buying plan remains an option.

To guard against a drop in price expectations, "more pre-emptive action may be warranted", he said in a speech entitled "Monetary policy in a prolonged period of low inflation".

Draghi's comments reinforced suggestions from other ECB policymakers that the bank is ready to act at its June 5 policy meeting to counter low inflation and weak lending in the 18-country euro zone.

Draghi said after the ECB's May meeting that the Governing Council was "comfortable with acting next time" - its June 5 policy meeting - but wanted to see updated economic projections from the bank's staff first.

He said he expected inflation, now running at 0.7 percent, to slowly return to the ECB's target of just under 2 percent.

"Our responsibility is nonetheless to be alert to the risks to this scenario that might emerge and prepared for action if they do," he said in introductory remarks at the ECB's new Forum on Central Banking at Sintra in Portugal.

"What we need to be particularly watchful for at the moment is, in my view, the potential for a negative spiral to take hold between low inflation, falling inflation expectations and credit, in particular in stressed countries," he said.

Setting out policy options for different scenarios, Draghi said that should exchange rate or market developments result in an unwarranted tightening of monetary and financial conditions "this would require adjustment of our conventional instruments".

Such instruments include cuts in interest rates, among them the ECB's deposit rate, now at zero. Cutting that rate below zero would see the ECB effectively charge banks for holding their cash overnight.

However, a Reuters poll of euro money-market traders showed a widely expected cut in the deposit rate would only have a limited impact on money-market rates in the currency bloc.

Reuters reported earlier this month that the ECB is preparing a package of policy options for its June meeting. It includes cuts in all its interest rates as well as targeted measures aimed at boosting lending to smaller firms.

Draghi indicated that full-blown, U.S.-style quantitative easing - printing money to buy assets - remained an option for the ECB, saying a destabilising of inflation expectations "would be the context for a broad-based asset-purchase programme".

"BRIDGING ROLE"

Draghi also fleshed out what he called an "intermediate situation" in which constraints on credit interfere with the ECB's monetary policy. That referred to the reluctance of some banks - particularly in the so-called periphery - to issue loans as they repair their balance sheets. The recovery would bring growing demand for credit, Draghi said.

"And at this point, for monetary policy to produce its full effects, there must be no binding constraints on credit supply through the banking system," he said.

But he warned that credit demand may pick up faster than banks can repair their balance sheets and new capital markets can be developed to complement bank lending.

"If, in this context, availability of term funding is a limiting factor on loan origination, then monetary policy can play a bridging role," Draghi said.

"Term-funding of loans, be it on-balance sheet - that is, through refinancing operations - or off-balance sheet - that is, through purchases of asset-backed securities - could help reduce any drag on the recovery coming from temporary credit supply constraints," he said.

The comments suggested the ECB could deploy a long-term lending facility - or LTRO - targeted at providing banks with funds to lend on to businesses and households, or else buy asset-backed securities (ABS) to support the provision of loans.

ECB Executive Board member Yves Mersch said on Saturday credit demand in the euro area showed signs of picking up, and banks needed to be strong enough to respond to that demand.

Hyun Song Shin, economics advisor and head of research at the Bank for International Settlements, said efforts to help smaller business were needed but would be hard to implement.

"We have a feast in bond markets and a famine in SME lending," he told the forum. "If we can drill a hole from very high liquidity in bond markets into bank lending, of course that would be exactly what we need, but actually doing that will be very challenging."

Draghi said credit constraints were hampering recovery in stressed countries, while the effects of an appreciating euro exchange rate would hold down euro zone inflation.

However, Stephen Cecchetti, Shin's predecessor at the BIS, thought the idea of developing an ABS market for loans from small- and mid-sized companies would be tricky.

"I would like to see an example somewhere in the world of someone who has successful securitised small- and medium-sized enterprise loans," Cecchetti said. "I don't think it is a very easy thing to do."

(Reporting by Eva Taylor; Writing by Paul Carrel; Editing by Larry King)

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