ECB mulls policy response to market turmoil over China

The European Central Bank looks set to keep its monetary policy gunpowder dry when its decision-making governing council convenes next week, despite the recent turmoil that has engulfed global markets, analysts said.

It has been a chaotic week for stock markets around the world, spooked by fears of economic slowdown in China.

Share prices have wildly seesawed, but trading received a lift later in the week from comments by US Federal Reserve officials, who said the current turmoil had weakened the case for a US interest rate rise in September.

The ECB, for its part, is unlikely to be panicked into any knee-jerk policy moves, particularly since its radical asset purchase programme known as quantitative easing, or QE, finally appears to be bearing fruit, central bank watchers said.

QE is an ambitious scheme, launched in March, to buy more than one trillion euros ($1.1 trillion) worth of public sector bonds to pump liquidity into the system.

The programme is indeed helping to get credit flowing again and pushing up the rate of inflation in the 19 countries that share the euro, new data suggest.

Hence, "in the short run, the ECB should not adapt its QE policy. This (would) only add to the turmoil," said Merijn Knibbe of Wageningen University in the Netherlands.

There is no reason for the ECB to start phasing out its ultra-loose monetary policy, where interest rates have been held at all-time lows since September 2014, the expert said.

Even Germany, Europe's biggest economy, where growth is picking up with confidence on the rise and its public finances firmly in the black, was showing no real signs of overheating, Knibbe said.

But Natixis economist Sylvain Broyer believes that the QE programme might have to be extended beyond the original planned date of September 2016.

In the current market turbulence, the euro was seen as a safe haven by investors, pushing market interest rates down and causing consumer price inflation to undershoot the central bank's target.

Such factors "will provide the ECB ample excuse to extend its QE programme beyond September 2016. But let us be clear: even without such turbulences, the ECB would have had to extend its QE programme, since core inflation will remain far below price stability for structural reasons," Broyer said.

Andrew Bosomworth at Pimco thinks the ECB "will not be forced by current market turbulences to extend or increase QE".

- Too early for China impact -

Lower oil prices meanwhile suggest that the ECB may have to revise downwards its inflation forecasts.

But it was "too early to tell how significant slower external demand growth from emerging markets, particularly China, will impact aggregate demand growth in the eurozone," Bosomworth said.

The ECB should look through the impact of lower energy prices on headline inflation and concentrate on the trend in the core measure.

"We expect core inflation to remain subdued around 1.0 (percent) through 2016 and to rise only gradually. An extension of QE beyond 2016 at this stage can therefore not be ruled out," he concluded.

Jennifer McKeown at Capital Economics said the rise in the euro exchange rate "has put the onus on the ECB to maintain and perhaps increase monetary policy support".

"We doubt that the bank will announce any policy changes following its meeting on Thursday as it downplays risks surrounding China. But with the lower oil price and stronger currency adding to deflation risks, president Mario Draghi is likely to stress that further support is possible in future and perhaps outline how this could be provided," McKeown said.

- 'Eurozone resilient' -

The positive effects of QE were seen in credit and money supply data published by the ECB last week.

After long months of contraction, the volume of loans to private businesses and households increased by one percent in July compared with the same month in 2014, the ECB said in a statement.

The previous month, private sector loans had increased by 0.6 percent.

The overall eurozone money supply grew by 5.3 percent in July from a year earlier, faster than the 4.9 percent recorded in June.

The ECB regards M3 money supply as a barometer for future inflation.

"The turmoil in emerging markets is hitting the eurozone at a time when the domestic fundamentals are better –- or at least much less fragile -- than they have been for many years," said Berenberg Bank economist Holger Schmieding.

"But the data available so far suggest that the eurozone is resilient enough to cope with an external shock with no more than modest damage," he said.

"The ECB's monetary stimulus is working its way through the system. Households and companies have money to spend, the credit cycle is turning up. The ECB's monetary policy is working," he said.