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ECB inflation cut report raises doubts over end to easing bias

The European Central Bank has been widely expected to drop its bias toward easier monetary policy June 8 but a reported cut to its inflation forecasts for the next three years has shaken investors' confidence in a change in guidance.

The ECB’s draft projections, to be published at its monetary policy meeting in Estonia, will now show consumer price growth at around 1.5% in each of 2017, 2018 and 2019, according to Bloomberg News, citing eurozone officials. The previous forecasts in March saw inflation figures of 1.7%, 1.6% and 1.7%, respectively.

The central bank was widely expected to leave rates unchanged and asset purchases at €60 billion per month, but the focus since its May meeting has been on whether president Mario Draghi would alter his wording to say that economic risks to the eurozone were now "balanced" rather than "tilted to the downside." Most economists expected this change, with a smaller number thinking it possible that the ECB would go further and remove its bias toward looser monetary policy by removing a reference to the possibility of interest rates being cut "to lower levels".

The euro plunged to an intraday low of $1.1204 on the Bloomberg report before recovering to $1.1235, around 0.4% down on the day.

"We were expecting inflation for 2017 to be downgraded, but if you take the reports at face value then a downgrade to 1.5% for 2019 would be a surprise," said Florian Hense, an economist at Commerzbank in London. "That would be quite a dovish statement and would appear to suggest QE would run through 2018."

Excuse to stay loose

The reported changes are to the ECB's projections for headline inflation, as opposed to the central bank's preferred 'core inflation' measure, which strips out price movements of more volatile products like food and energy.

That gives Draghi the opportunity to continue with the cautious approach he has so far taken when discussing the broadening European economic recovery. Following surges in headline inflation earlier in 2017 he stressed that the governing council ignores "transitory factors" and would need evidence of a "broad and sustainable" rise in core inflation before changing stance.

Elwin de Groot, head of macro strategy at Rabobank in London, told S&P Global Market Intelligence that the reported inflation forecast cuts had not changed his view on what the ECB would do June 8.

"I was slightly surprised by the size of the revisions," he said. "For 2017 I can understand that, as it is driven by things like energy prices and the strength of the euro, but on the change to the forecast for 2019 I am not so sure."

De Groot believes changing the wording on economic risks from "downside" to "balanced" will be Draghi's chosen middle ground.

"The market will see that as really carrying relatively little weight, but [by changing the language] you are at least communicating to the market that you are taking baby steps towards the exit."

Improving eurozone growth and inflation figures in recent months have put pressure on Draghi to begin the process of winding down the extraordinary level of stimulus via record-low interest rates and quantitative easing, which has seen the ECB's balance sheet balloon to well over €4 trillion.

Options limited

The changes to the inflation forecast may do little to sway hawks on the ECB's governing council and executive board who believe prolonging stimulus will ultimately do more harm than good.

German executive board member Sabine Lautenschläger, in a speech in Berlin on June 1, said that "all ingredients for an appropriate increase in prices" were present and that "hesitating for too long only creates new problems."

She may have support from French executive board member Benoît Cœuré, who has also warned against moving too slowly in tightening policy for fear of causing a bigger shock down the line.

Cœuré is the ECB's head of market operations and may have more practical concerns about prolonging its €60 billion-per-month asset purchase program, according to Rabobank's De Groot.

Having bought up nearly €1.6 trillion of eurozone government debt, the central bank is approaching the maximum amount of bonds it can buy in some countries, notably Germany.

"The ECB will either have to accept that there is only limited time left to make an exit, or the Council may need to change some of the parameters again," he said. "Given the growing resistance to the bond purchases within the Council and the improved economic outlook, the latter may not be an option."