Falling inflation puts ECB easing bias to test

(Reuters) - European Central Bank policymakers meeting on Thursday face a dilemma after a surprise fall in inflation brought the euro zone closer to slipping into deflation, but with the growth outlook intact they might hold off on action for now.

Annual inflation in the currency bloc slowed to 0.7 percent in January, well below the ECB's target of just under 2 percent, venturing deeper into what ECB President Mario Draghi has dubbed the danger zone.

A month ago, Draghi set out markers for further action, pledging that the central bank would take action if its inflation outlook worsened or money markets saw "unwarranted" tightening.

The bank may want to be seen to be ahead of the curve. In November, after an inflation reading of 0.7 percent, it took hasty action and cut interest rates to 0.25 percent.

Bets on it acting again this month have increased since data showed inflation slipped back to that level in January.

However, it is not clear whether the January data will have been alarming enough. After the November reading, inflation edged up again in December, so policymakers may want to wait until the bank's updated staff projections come out in March.

"The surprisingly soft numbers for January CPI make the outcome of Thursday's ECB meeting a close call," Unicredit economist Marco Valli said. "We still expect interest rates to be left unchanged and no new unconventional measures (taken) ... but the risk of immediate action has risen."

Money-market traders expect no change in interest rates on Thursday, or any other steps to combat falling inflation or prop up the euro zone, according to a Reuters poll taken on Monday.

The ECB does not have a lot of ammunition left to boost inflation, which may make it reluctant to act too quickly. There might be only one more rate cut in its arsenal and even that would be smaller than the traditional quarter point.

If inflation were to fall further instead of the expected gradual pickup, the ECB would act.

The bank's inflation outlook for 2015 in its March staff forecasts will be crucial - a cut from December's 1.3 percent would bring huge pressure to act.

For now, economic recovery is intact, though still in its infancy. The euro zone's private sector logged its busiest month in 2-1/2 years in January, with Germany leading the upswing, surveys showed on Wednesday.

STERILISATION

At Thursday's meeting, ECB policymakers will also discuss emerging markets, which have come under pressure as concerns about a possible slowdown in China's economy and the U.S. Federal Reserve's stimulus wind-down triggered an exodus of foreign capital.

The fear in the euro zone is that falling emerging market currencies and weak demand in those economies would add to downward inflation pressures in the euro zone. The impact so far has been muted enough for the ECB not to act.

"It's not significant enough yet," ABN Amro economist Nick Kounis said. "We've not seen moves in markets which would start to change the outlook for inflation."

The euro exchange rate has remained tolerable and is near two-month lows both against the U.S. dollar and on a trade-weighted basis.

Besides low inflation and emerging market turmoil, short-term interest rate volatility has been another headache for the ECB.

To prevent spikes in market rates, the bank could choose to end offsetting its government bond purchases, which would immediately add about 175 billion euros to the money markets. Sources have told Reuters, though, that this week might be too early for the move.

A further complication is that by refraining from action, the ECB risks making it more difficult to convince markets of its easing bias and keep the euro from shooting up.

"To reel out the same lines with no action, that would not be very welcome," ABN Amro's Kounis said. "Financial markets have become numb to this kind of talk."

(Editing by Susan Fenton)