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Draghi downbeat on inflation; euro falls on increased prospects of December move

Expectations of further monetary stimulus by the European Central Bank were heightened again today following ECB President Mario Draghi’s testimony to the European Parliament. At the hearing to the Economic and Monetary Affairs Committee, Draghi said that “signs of a sustained turnaround in core inflation have somewhat weakened”.

The ECB’s Governing Council will convene on December 3 for its next policy meeting and recent reports have suggested that a consensus is forming with policymakers to cut the deposit rate further into negative territory. Markets have already priced in a 0.10% reduction in the deposit rate from -0.20% to -0.30%.

Draghi had hinted at the ECB’s October meeting that they will re-examine monetary policy at the next meeting based on the latest economic projections to be published by then. He reiterated the possibility of extending the asset purchase program beyond the September 2016 timeline and called quantitative easing a “powerful and flexible” tool. Draghi added that other instruments could also be used. There have been reports that one such instrument being considered is the purchase of municipal bonds of Eurozone cities.

Like the Bank of England, the ECB is putting more emphasis on the downside risks from global events than the US Federal Reserve, which is getting ready to lift rates in December. Draghi said the “downside risks stemming from global growth and trade are clearly visible”. He also said the protracted weakness of past years in the Eurozone is weighing on wage growth and this is likely to delay the time it takes for inflation to normalize by more than initially anticipated.

Despite the dovish comments, Draghi said that the Eurozone recovery is “stronger and broader” than in the past and is currently being driven by consumption and investment. He also stressed the danger of keeping interest rates low for too long period of time and that the risks to financial stability must be closely monitored.

Most analysts now expect some form of monetary easing to be announced in December. However, some market commentators are questioning the effectiveness of increasing the size of the ECB’s asset purchase program given the concerns about possible shortage of eligible assets to buy. On the other hand, lowering the deposit rate might prove more effective, especially in putting further downside pressure on the euro. Not everyone within the ECB is convinced though about the need to cut rates. The head of Estonia’s central bank, Ardo Hansson, said on Wednesday that there was no need to lower rates just yet.

The euro initially nosedived below the 1.07 handle to a low of 1.0690 dollars but later rebounded to 1.0733 in late European trading as traders were cautious about further dollar gains ahead of speeches by several Fed officials later today. Against the pound, the single currency touched a 3-month low of 0.7040 before recovering to 0.7067. The euro also reversed its losses against the yen to climb to 131.95 after dropping to 131.47 yen on the comments.

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