ECB to highlight growing inflation, economic risks

By Balazs Koranyi

FRANKFURT (Reuters) - The European Central Bank will keep all interest rates on hold when it meets on Thursday but highlight increasing growth and inflation risks, raising the prospect of further policy easing later this year.

Meeting for the first time since it cut rates and expanded its asset purchase programme in December, the ECB is expected to warn that inflation could stay ultra-low longer than an already downbeat forecast pegged on plunging oil prices, weak Chinese growth and the lack of decisive fiscal policy action at home.

It will also need to address renewed turmoil in the bank sector with shares in Italian, Portuguese and Greek lenders plunging on concerns the ECB may eventually force them to take a loss on some of their bad loans, reducing their ability to pay dividends.

ECB President Mario Draghi could also unveil further detail after Thursday's meeting about the bank's plan to buy municipal debt, highlighting flexibility in asset purchases even as some investors warn about the possible limits of the scheme.

But having raised expectations too high in December, he will hold short of making concrete promises, emphasizing instead the bank's readiness and ability to act.

"We expect only a shift in rhetoric, albeit a significant one," JPMorgan economic Greg Fuzesi said. "Draghi will emphasize that there has been a deterioration in the assumptions underlying last month's 'adequate' recalibration of the policy stance."

The ECB's December projections were based on crude prices averaging $52.2 this year, but Brent crude is trading around $28 per barrel and even 2022 oil futures are below $50, indicating little investor confidence in a quick rebound.

CREDIBILITY

Some ECB policymakers have argued that it should focus on core inflation, which strips out energy and food.

But low energy prices are now impacting other goods and services, pushing even core inflation far from the bank's goal of close to 2 percent and jeopardizing the credibility of that target.

"There is a risk that the world at large stops believing that the ECB will deliver on its target," ABN Amro economist Nick Kounis said. If that happened, "very low inflation could become entrenched."

The ECB earlier estimated that a 10 percentage point change in oil prices would change headline inflation by about 0.2-0.3 percentage point in the first year, with a further, second-round effect coming later.

Once companies stop believing in the inflation target, they might also curb wage growth, in turn putting a brake on the economy and raising the risk that entrenched low inflation could spiral into deflation.

CHINA CRISIS

Draghi, who holds his news conference at 1330 GMT, will emphasize the bank's 1.5 trillion euro quantitative easing programme has flexibility, giving the bank plenty of room to act.

Minutes from the bank's December rate meeting also indicated a greater willingness on the part of policy makers to cut the deposit rate further. Many analysts predict that rate - which at -0.3 percent already charges commercial banks to park cash at the ECB - could drop by another 10 basis points as soon as June.

"(That) remains the low-hanging fruit and is priced by the third quarter," Deutsche Bank said. "An extension of the time-frame of quantitative easing would have limited market impact."

Draghi's view on China could also shift significantly.

In December, policymakers argued that earlier concerns about developments in China had not been borne out.

But stock market turmoil there since the start of 2016, a falling yuan and the weakest full-year growth figure in a quarter century suggest the risks have in fact increased.

An even weaker yuan would export China's deflationary risk and reduce the effectiveness of any rate cuts by limiting the ECB's ability to weaken the euro.

Weakness in China could also persuade the U.S. Federal Reserve to slow its rate increases, also putting the euro under firming pressure.

(Reporting by Balazs Koranyi; editing by John Stonestreet)