ECB set to dial back stimulus one more notch By Reuters

© Reuters. FILE PHOTO: The HSBC HSBC foreign exchange securities dealerEuropean Central Bank (ECB) logo in Frankfurt, Germany, January 23, 2020. REUTERS/Ralph Orlowski/File Photo

By Balazs Koranyi and Francesco Canepa

FRANKFURT (Reuters) -The European Central Bank is all but certain to dial back stimulus one more notch on Thursday while pledging to keep borrowing costs exceptionally low, sticking to its long-held view that alarmingly high inflation will abate on its own.

With the euro zone's economy now back to its pre-pandemic size, pressure is mounting on the bank to follow its global peers, particularly the U.S. Federal Reserve, in turning off the money taps.

But policymakers are also fearful that stepping back too quickly could unravel years of work to rekindle once anaemic inflation.

The ECB's dilemma is encapsulated by an unusually uncertain outlook, which could prompt rate-setters to delay many of their big decisions until the new year, leaving policy exceptionally flexible with limited commitments.

The Fed's signal on Wednesday that it would end pandemic-era bond purchases in March and raise rates three times next year further complicates life for the ECB, as the world's two biggest central banks are now moving in opposite directions, a source of market turbulence in the past.

The ECB's compromise is likely to be clarity on its policy framework in 2022, with details to be filled in as policymakers gain confidence that inflation, now running at more than twice the bank's 2% target level, comes down quickly in 2022.

What appears certain is that bond buys under a 1.85 trillion euro Pandemic Emergency Purchase Programme will be reduced next quarter then wound down at the end of March. A long-running Asset Purchase Programme, however, will be ramped up, offsetting some of this lost stimulus.

Still, overall purchases could be left at around 40 billion euros a month, less than half of their current size, a Reuters poll of analysts showed.

The effective cut in stimulus could be much smaller though as fresh government debt issuance is expected to fall, so the ECB will continue to hoover up most of the new debt, pinning borrowing costs near record lows.

The ECB is also likely to signal that it will keep buying bonds throughout the year, in a bid to keep yields in check and to rule out any rate hike in 2022.

The policy decision is due at 1245 GMT, followed by ECB President Christine Lagarde's news conference at 1330 GMT.

MOVING PARTS

Beyond that, a plethora of options remain on the table.

The problem is that while the ECB will project inflation falling back under target in 2023 and holding there in 2024, a number of policymakers doubt this narrative, warning that even if driven by one-offs, high price growth could get entrenched.

"The exact calibration of measures is almost impossible to get 100% correct given the many moving parts – and the ECB has surprised us many times with new and innovative thinking," Danske Bank economist Piet Haines Christiansen said.

"We expect the ECB would want to keep optionality, but naturally that comes at the expense of a firm forward guidance.

The most likely option is that ECB policymakers approve a bond purchase quota or "envelope" for 2022 and emphasize that not all of this must be spent.

The bank will then regularly review the exact volumes and set purchase targets only for short periods, much like it did in recent months.

The biggest risk is that investors start dumping bonds from the bloc's indebted periphery, increasing the premium governments there need to pay to borrow.

The spread between German and Italian debt has steadily widened over the past two months and now stands around 129 basis points, a comfortable level but up from levels around 90 basis points early this year.

To mitigate this risk of fragmentation, the ECB could say that the roughly 100 billion euros left in the emergency programme could still be used in case of market turbulence and cash from maturing bonds may be used flexibly, so it could spend more in stressed markets.

"Rarely has the backdrop for a major ECB decision been as uncomfortable and as uncertain as it is now," Berenberg said in a note to clients.

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