* Inflation slows to 0.7 pct; far below ECB target
* ECB meets next Thursday
* Medium-term inflation outlook, money markets key for ECB
* ECB's Coeure says cenbanks can act even when rates at zero
By Martin Santa and Paul Carrel
BRUSSELS/FRANKFURT, Jan 31 An unexpected drop in
euro zone inflation raises pressure on the European Central Bank
to consider fresh policy action next week to counter deflation
risks and support a weak euro zone recovery that may be running
out of steam.
Inflation slowed this month to 0.7 percent from 0.8 percent
in December, confounding market expectations for a rise to 0.9
percent and matching a low hit last October. The ECB responded
then by cutting its interest rates to record lows.
The latest weakening of price pressures took the inflation
rate further below the ECB's target of just under 2 percent and
will fan investor concerns that deflation may be gripping the
18-member bloc as it starts to exit a sovereign debt crisis.
The inflation data would "set alarm bells ringing at the
ECB," said Commerzbank economist Peter Dixon, adding:
"With some of the sentiment numbers in the course of recent
weeks having beaten expectations, I don't think it is going to
be time next week for the ECB to press that panic button".
A survey released last Thursday showed the euro zone's
private sector started 2014 in much better shape than expected,
with stronger growth across the region marred only by a
continued downturn in France.
The ECB's policy conundrum is complicated by a sell-off in
emerging markets that risks pushing up the euro's exchange rate
- a development that would keep downward pressure on prices and
could snuff out the robust start to 2014 for business.
ECB policymakers meet next Thursday.
Highlighting the bank's capacity to act if it wants to,
Executive Board member Benoit Coeure said central banks have
tools available to lift low inflation back to target even when
interest rates are at zero.
"There are monetary policy instruments that could be used in
the event of downward risks to medium-term price stability, even
if the nominal interest rate is constrained by the zero lower
bound," Coeure said.
After their January policy meeting, ECB President Mario
Draghi set out two scenarios that could trigger fresh policy
action: a deterioration in the medium-term inflation outlook and
an "unwarranted" tightening of short-term money markets.
The ECB will present fresh economic forecasts from its staff
in March, and a downward revision to the inflation or growth
projections could prompt the Governing Council to ease policy.
Although the ECB cut in November after the slowdown in
inflation a month earlier, policymakers on the 24-member
Governing Council focus on the medium-term outlook rather than
monthly swings in prices.
"If they are going to cut rates, which I think they will,
it's more likely that they will hold off until March," said
Speaking in Budapest, ECB Governing Council member Ewald
Nowotny said he expected very weak growth in the euro area this
The outlook remains fragile despite the ECB's move last
November to cut its main interest rate to a record low of 0.25
percent, and to lower the deposit rate it pays banks for holding
their cash overnight at the central bank to zero.
In money markets, the second potential trigger for ECB
action, a reduction in the amount of excess cash sloshing around
in the financial system put upward pressure on overnight lending
rates early this year.
Banks stocked up on ECB cash this week, however, and are
easing back on early repayments of ECB crisis loans. Together,
these factors are expected to keep enough excess cash in the
system to hold down short-term market rates.
After the release of the inflation numbers on Friday,
short-term money market rates fell on increased bets that the
central bank will ease policy further later this year.
Money market rates suggest investors expect the ECB to hold
fire at its meeting next week: forward overnight bank-to-bank
euro lending rates dated for the February meeting, at 0.18
percent are higher than the spot Eonia rate of 0.155 percent.
The downward trajectory of money market rates maturing
beyond February, however, indicates expectations the ECB may
ease its policy later this year.
A separate Eurostat data release on Friday showed the euro
zone unemployment rate stuck near a record high at 12 percent
for the third month running. It is widely expected to ease only
very modestly in the coming quarters.
"We expect further falls in inflation going forward," said
Nick Kounis at ABN Amro. "The high levels of unemployment and
strong euro all suggest there is further downside."
Kounis suggested the ECB could stop weekly operations to
sterilise its holdings of government bonds bought under a
terminated bond-buy programme - a step that could increase the
money supply and fuel inflation.
"If that doesn't work there could be a rate cut in March or
April. It would be a mini-cut, it's not our central call but
maybe 10 basis points," he said.