FRANKFURT (Reuters) - A shock slump in euro zone inflation to a level way below the European Central Bank's target is focusing the minds of its policymakers, who have the chance to respond at Thursday's monthly meeting.
While they may choose to wait for updated medium-term economic forecasts in March before deciding whether to act, the drop in inflation to just 0.7 percent last month highlights the immediacy of the deflation risk facing the 18-country bloc.
After the ECB's January policy meeting, 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.
ECB policymakers have discussed - in theory - a number of policy measures they could deploy to deal with either of these scenarios. Each comes with its own merits and drawbacks.
Following is a description of some of the main options and their respective pros and cons.
With the ECB's main interest rate already at just 0.25 percent, the central bank is running out of room to lower official borrowing costs. Analysts polled by Reuters last month did not expect the ECB to cut rates within a forecast horizon extending to June 2015. [ID:nL5N0L32MW] Should the ECB opt to lower rates, it would probably go with a smaller cut than the 25-basis-point increment it has always used - to 0.1 percent, for example. Such a step would send a signal that the ECB is ready to act to meet its inflation target, but would have only a muted impact on the economy.
The ECB's other key interest rate, the deposit rate it pays banks leaving their money with it overnight, now stands at zero. Lowering this into negative territory would see it effectively charge banks to hold their money securely. This would give banks a greater incentive to lend, rather than parking funds at the central bank. The ECB says it is technically ready to make this move. When Denmark introduced negative deposit rates in 2012, however, banks simply increased their loan rates to make up for having to pay the central bank to hold their money.
The ECB has discussed the possibility of suspending operations to soak up money it spent buying sovereign bonds during the euro zone's debt crisis under its now-terminated Securities Markets Programme. [ID:nL5N0L92MG] Ending the so-called "sterilization" operations would inject about 175 billion euros ($236.43 billion) of liquidity into the financial system, which would help ease strains in euro zone money markets.
One argument against suspending the sterilization operations would be to avoid raising questions about ECB policy ahead of a ruling by the German Constitutional Court on the central bank's new bond-buying programme.
The court is considering whether the ECB's plans to buy "unlimited" amounts of bonds from stricken euro zone states, announced in 2012 at the height of the crisis, is really a vehicle for funding member states through the back door. That could violate German law.
Purchases made under the yet-to-be-used bond plan are also meant to be sterilized to stop them fuelling inflation.
The ECB funneled over 1 trillion euros into the financial system in late 2011 and early 2012 with twin three-year long-term refinancing operations (LTROs) at low interest rates. The move provided banks with ample liquidity, giving them more certainty about their funding situation and taking tension out of money markets. But banks have been repaying big chunks of the loans early so there is no guarantee they would jump again at a repeat offer, especially as they are tidying up their books ahead of a health check of the banking sector by the ECB.
Quantitative easing (QE) - effectively, printing money - would be a way to flood the economy with funds. By buying government bonds on the secondary market, the ECB could bring down market interest rates and ease money market tensions. The increase in the money supply would, in theory, also push up prices and stave off the deflationary threat. Although the ploy has been used by the U.S. Federal Reserve, the Bank of Japan and the Bank of England, many ECB policymakers have deep reservations about making this move, from which they fear it would be difficult to exit. Another concern is that the merits of QE are unclear: in the United States, a quicker clean-up of the banking sector than in Europe may have been the decisive factor in pepping up the economy, not QE.
The ECB has vowed to keep its key interest rates "at present or lower levels for an extended period of time". But how long is an 'extended period'? To help anchor inflation expectations, the ECB could sharpen its language. The Fed did this by tying its guidance to developments in the U.S. labor market, but a problem for the ECB may be that its mandate is to focus on price stability, not the broader economy. The Bank of England's recent experience may also not inspire the ECB to refine its message. Its forward guidance was rendered virtually obsolete last month when Britain's jobless rate fell close to the 7.0 percent level the BoE set in August as a threshold for considering higher interest rates, confident it would take years to get there.
Writing by Paul Carrel; Editing by Catherine Evans