Euro strength worries ECB as October stimulus decision looms

FRANKFURT (Reuters) - The euro’s strength is already weighing on inflation and will be a key factor for the European Central Bank next month when it decides how to proceed with its massive stimulus programme in 2018, ECB President Mario Draghi said on Thursday.

The euro, which has gained 14 percent against the dollar this year is “very important” and needs careful monitoring, Draghi said after keeping rates at record lows and leaving the door open to even more stimulus if necessary.

His cautious comments raise the chances that the ECB will opt to phase out its 2.3 trillion euro (£2.10 trillion) bond buying scheme only very slowly next year, despite solid economic growth in the euro zone and worries about real estate bubbles in richer countries such as Germany.

A sharp rally in the euro since the start of the summer was the main reason for a downgrade in the ECB’s new 2018-19 inflation forecasts, which are now even farther away from the ECB’s target of almost 2 percent.

“The medium-term outlook for inflation was revised downward in the staff’s projections, mainly due to the appreciation of the exchange rate, which means that we will have to take into account this element in our information set in our future policy decisions,” Draghi said.

Confirming a Reuters report from last week, Draghi added that there was now broad consensus within the ECB that currency volatility was a “source of uncertainty” in formulating monetary policy [L8N1LO49T]

Underlining the dilemma faced by the ECB, the euro hit a nine-day high above $1.20 as Draghi spoke, as investors piled into euro zone bonds on the prospect of continued ECB buying.

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The ECB decided to retain the option to boost its bond purchases if needed, suggesting policymakers are still far from contemplating the end of the programme.

“The recalibration will be very gradual with a particular attention accorded to the market reaction to rates, spreads and forex as they impact financial conditions,” Gilles Pradère, a portfolio manager at RAM Active Investments, said.

The key problem for the ECB in deciding whether to continue or wind down the asset purchases is that while growth is robust, inflation will remain under the ECB’s target for years to come given a sizable slack in the labour market and the absence of meaningful wage growth.

Indeed, while the ECB upgraded some of its growth forecasts and predicted a faster decline in unemployment, it also cut its inflation projection.

The bank now sees price growth at 1.2 percent next year compared with 1.3 percent predicted in June, and at 1.5 percent in 2019, down from 1.6 percent forecast three months ago.

While no projections for 2020 will be made until December, Draghi said he personally expected inflation to converge with the ECB’s target in 2020.

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Though the ECB has preferred to tailor its message by the smallest of increments, time is running out for a decision as the scheme is due to end in December. The bank has only two more rate meetings this year, on Oct. 26 or Dec. 14.

Draghi simply reiterated that policymakers would decide this autumn, adding: “Probably the bulk of these decisions will be taken in October.”

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Such a timeline suggests that the ECB could still make some or all of the key decisions at the December meeting, just weeks before the current scheme is due to end.

Hawkish rate-setters led by Germany argue that bond buying has reached its potential so it should be wound down. But “doves” say that a rapid exit could tighten financial conditions too much, undoing the programme’s successes.

Analysts polled by Reuters predicted no policy change on Thursday and expect bond buys to be cut by one-third in a decision later this year.

“Even though the ECB failed to present details of a game plan, the ECB’s intentions are clear: prepare a very smooth tapering without pushing up interest rates and with as little further euro appreciation as possible,” ING economist Carsten Brzeski said.

“In our view, this could mean a somewhat softer tapering than we initially thought, announcing at the October meeting a reduction of the monthly purchases to no less than 40 billion euros starting in January,” he added.

Draghi said the “sequencing” of the ECB’s policy path had not been discussed, meaning interest rates would only be raised after the bond purchases have ended.

He also said that there was no discussion of the so-called issue limit, which limits the ECB in buying up to one-third of each country’s debt, and there was no talk of including new instruments into the programme.

Additional reporting by John O’Donnell; Writing by Mark John; Editing by Catherine Evans and Hugh Lawson