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Europe's central bank weighs anti-deflation steps
ECB head Draghi has all but promised action at Thursday's meeting
By BY DAVID McHUGH
Associated Press
2014-06-05 03:01 AM

FRANKFURT, Germany (AP) -- There's little doubt among analysts: Following heavy hints from its president, Mario Draghi, the European Central Bank will almost certainly take action on Thursday to help stoke inflationary pressures across the 18 countries that use the euro.

Annual inflation in the eurozone is only 0.5 percent, a clear sign that the recovery remains wobbly. If it persists, low inflation threatens to make it harder for companies and countries to work off excessive levels of debt left over from the eurozone's debt crisis.

Worse, subpar inflation -- way below the ECB's target of just below 2 percent -- has raised worries about an outright fall in prices, also known as deflation. When prices fall, people hold off making purchases as they anticipate cheaper bargains down the line. It's an economy killer -- just look at the anemic growth experience of Japan for much of the past two decades -- and a hard trap to get out of once you've fallen in.

Waning energy prices and a strong euro that's reduced the price of imports have been blamed for a large chunk of the fall in inflation. In countries such as Greece, where the government has sharply held back government spending and state salaries in return for bailout loans from other countries, falling prices have been a consequence of deliberate policy.

Here are some of the weapons the ECB's 24-member governing council could decide to use at the meeting in Frankfurt, Germany.

RATE CUT: Most analysts think a cut in the bank's interest benchmark, the refinancing rate, from its current record low of 0.25 percent is a near certainty. That's the rate at which banks can borrow from the ECB. It heavily influences market rates at which banks lend to each other.

If banks pass on those lower rates to customers, a cut in the refinancing rate can mean lower borrowing costs across the economy. It's already very low, so another cut might only bring marginal help. With eurozone growth at only 0.2 percent in the first quarter, any help however is welcome.

Perhaps the biggest help from rate cuts would be holding down the euro's exchange rate against the dollar. Lower rates reduce investor returns, and thus can reduce demand for investments in a particular currency. Draghi's statement May 8 that the bank was "not resigned" to the current low inflation and was "comfortable" taking action in June made markets think a rate cut was a sure thing -- and sent the euro down from 2 ? year highs around $1.40 to around $1.36.

In fact, markets have gone so far they may have set themselves up for disappointment.

Holger Schmieding at Berenberg Bank said a rate cut on its own "without any further initiative could be a negative surprise." Markets, he added, "may then partly erase the moves of the past four weeks."

GOING NEGATIVE: A further, and more unusual step, would be a negative interest rate for excess funds that banks deposit at the ECB. Currently the rate is zero. The idea is, a negative rate of, say, 0.1 percent, could push banks to lend that money instead of stashing it away. Yet the consequences are unpredictable. It could burden bank finances at a time when the ECB is pushing banks to shed bad loans and assets and strengthen their finances.

LOANS FOR THE LITTLE GUY: Draghi has repeatedly called for a way to increase credit to small businesses. Banks aren't passing on cheap ECB rates because the banks have shaky finances themselves, or are simply unwilling to risk lending in an uncertain economy. Analysts speculate the ECB may offer a large blast of cheap credit to banks, with some link to their having to lend it.

The ECB could also buy packages of small business loans in the form of bonds. Problem is, there aren't many such bonds around to buy. An ECB offer to buy them, however, might stimulate the market in such bonds, known as asset-backed securities.

BIG BAZOOKA: Many economists have said pumping large amounts of newly created money into the financial system through large-scale bond purchases is the best way to reflate the economy. After all, that is what the U.S. Federal Reserve and the Bank of England did.

However, it's considered the least likely. The measure faces legal, political and practical obstacles in an 18-country currency union. For one, buying government bonds raises the question of whose bonds to buy. A massive bond market intervention could lower borrowing costs -- but most companies in Europe get credit from banks, not bond sales.

KEEP TALKING: At his news conference Draghi may hold the door open for more stimulus measures down the road if they're needed -- especially if the bank stops short of measures beyond a rate cut. Much may then depend on how convincing he is.

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