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ECB's Praet warns of deflationary pressures in euro zone

The European Central Bank's chief economist said on Friday the euro zone faces deflationary pressures, and the bank's president stressed that interest rates must remain low "because the economy is weak".

With euro zone inflation running at 0.7 percent, well below its target of just under 2 percent, a raft of ECB speakers this week have said it is open to taking fresh measures to support the economy.

Vice-President Vitor Constancio said on Tuesday "everything is possible" and both he and economics chief Peter Praet have said asset buying - or quantitative easing (QE) - is an option after years in which the bank's policymakers have ruled it out.

But the more conservative minority at the bank, who voted against this month's surprise cut in interest rates and are led by its German members, still seem dead set against any such move.

President Mario Draghi has taken a measured line, on Thursday pouring cold water on the idea the bank was actively considering moving deposit rates into negative territory and on Friday stressing the need to keep interest rates low.

"I understand the concerns about a prolonged period of low returns on savings. But it is important to understand that interest rates are low because the economy is weak," Draghi told the European Banking Congress in Frankfurt.

"If we raised rates, we would further depress the economy, people would lose their jobs, and then their savings would be lower for longer."

Praet, who sits on the ECB's six-strong Executive Board, said the financial crisis had saddled the euro zone with a debt burden unique in Europe's post-war history because it has created a more deflationary environment.

"This is a very different context for the correction of expectations (about income), which is more of a debt overhang," he told a conference at the Bank of France.

"It has more signs of a balance-sheet recession, which is a priori more of a deflationary environment than what we had in the 1960s."

Another ECB policymaker, Austria's Ewald Nowotny, told reporters in Paris the euro zone was not in deflation, adding: "I do not see a perspective of deflation.

Nowotny is known to have sided with the ECB's hawks in the past and all of this week's sounding off still added up for economists to a solid divide between the factions.

"They stand ready to act as the November cut proves but they don't yet see a genuine risk of deflation which demands throwing the kitchen sink (at the problem)," said RBS economist Richard Barwell. "A lot of the chatter is just reminding markets that they still have a sink to throw if they need to."

Money Printing

The economic case for moving was not aided by an above-forecast Ifo sentiment survey out of Germany - one of the month's most watched indicators. It suggested the euro zone's largest economy continues to recover slowly but has also had a habit of looking more positive than the hard, state-published data on output over the past few months.

The OECD threw its weight behind the QE idea this week but, in a telling sign of the fierce resistance such an option would face from ECB hawks, Bundesbank chief Jens Weidmann said printing money is not the way out of the euro zone crisis.

Berlin's finance minister Wolfgang Schaeuble also said bluntly on Thursday that the bank should not offer "false monetary stimulus" - a reflection of the long-standing concern in Germany with money-printing and its inflationary risks.

For the moment, the ECB is more likely to conduct another long-term liquidity injection, or LTRO, like the operations which funneled over one trillion euros in 3-year loans to banks in late 2011 and early 2012 at an interest rate tied to its main refinancing rate. A Reuters poll of money market traders pointed to that happening in the first quarter.

But even an LTRO could meet resistance from some Council members. Weidmann said on Thursday the ECB must ensure its lending operations do not become too generous.

"Everything is on the table and will be discussed, with liquidity measures the most likely option," said Berenberg bank economist Christian Schulz.

"But given the sharp reaction in the German media after the rate cut and the firm opposition to any further step in the central European caucus in the ECB, I think Draghi will not force more right now," he added.

[Source: By Ingrid Melander and Paul Carrel, Reuters, Paris and Frankfurt, 22Nov13]

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