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Low inflation to spark policy debate, but ECB seen holding steady

An illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in the late evening in Frankfurt January 8,
An illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in the late evening in Frankfurt January 8,

By Eva Taylor

FRANKFURT (Reuters) - The European Central Bank is not expected to announce any new measures on Thursday to boost the euro zone economy, although inflation dropping to close to zero could well prompt active discussion about stimulus.

Negative deposit rates - charging banks to deposit at the ECB - and some form of asset-buying program may lie further out.

Euro zone annual inflation ticked down to 0.5 percent in March, its lowest since the economy was deep in recession in 2009, and its sixth month in what ECB President Mario Draghi has called "the danger zone" below 1 percent.

The fall in inflation was slightly sharper than expected, and gave ammunition to those on the ECB'S Governing Council who want do more to stem the threat of deflation.

However March's inflation reading is not seen prompting policy action right away, as it is not much weaker than the ECB's forecast last month and was driven by the kind of softer food and energy prices the bank usually judges as temporary.

"Did the inflation outlook deteriorate compared to last month? I don't think so," said Anders Svendsen, chief analyst at Nordea. "It would be odd to do something now that they could have done last month and chose not to."

The ECB refrained from taking further action in March despite forecasting inflation would undershoot its target of below but close to 2 percent well into 2016, which disappointed the market and pushed up the euro exchange rate close to $1.40, its strongest level since October 2011.

Since then, several policymakers have talked about what the ECB could do should the exchange rate weigh more on inflation and if the risk of deflation became more serious.

A levy on banks' overnight deposits at the ECB was seen as the preferred tool to temper a currency rise, while the hurdle to start printing money - as central banks have done in the United States, Japan and Britain - remains high.

A Reuters poll on Monday showed that 18 out of 22 euro money market traders expect interest rates to remain at 0.25 percent.

The findings are in line with a separate Reuters survey conducted last week which had only two of 72 economists calling for the central bank to act on Thursday.

ECB TOOL BOX

The ECB has set out two scenarios that could prompt fresh action: a deterioration in the medium-term inflation outlook and an "unwarranted" tightening of short-term money markets.

The latest inflation figures did not trigger either, economists said.

"Slower increases in food prices largely explain inflation's decline," said Bill Adams, senior international economist for PNC Financial Services Group. "The ECB, like most central banks, tends to 'look through' volatility in food prices to target trend price pressures."

Economists also expect inflation to rebound in April, due to the later date of Easter this year than in 2013. However the low inflation reading sparked fresh calls for more easing from the International Monetary Fund on Monday.

With interest rates close to zero, the room to maneuver is limited and another cut in the main refinancing rate would probably be accompanied by a cut in the deposit rate, now at zero, an unprecedented move policymakers seem to be warming to.

None of the major central banks have used a negative deposit rate, which means that banks have to pay to park their money at the ECB overnight, giving them an incentive to lend while making euro-based assets less attractive and weakening the currency.

Last week, Finland's Governor Erkki Liikanen said a negative deposit rate "isn't any longer a controversial issue". His German colleague on the Council, Jens Weidmann, said the tool would be his preferred choice to address a strengthening euro.

Weidmann also said buying assets was not "out of the question" for the ECB, acknowledging that limited room to cut interest rates further required an assessment of the other policy tools, even if action was not needed so far.

Such a step is difficult to implement in the 18-member euro zone, as deciding which countries' assets to buy, whether to focus on government or private sector debt, and what quantity to purchase will be crucial to the success of the program.

The Bank of England, for example, spent 200 billion pounds ($333 billion) on gilts in its first round of QE between March 2009 and January 2010, which was equivalent to just over a fifth of the gilts then in issue.

The British central bank said this probably added 1.5 to 2.0 percent to its gross domestic product (GDP) and increased inflation by 0.75 to 1.5 percentage points.

But starting to buy assets from banks now would also send a mixed message to the market. The ECB is trying to clean up the banking system by putting euro zone lenders through a tough health check before it becomes their supervisor in November and large-scale purchases could be perceived as helping banks out.

"The bar for outright government debt purchases remains very high: they will be the weapon of last resort to be deployed only if full-blown deflation were to hit," said Unicredit's chief euro zone economist Marco Valli.

($1 = 0.5998 British Pounds)

(Additional reporting David Milliken Editing by Jeremy Gaunt)

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