Draghi puts euro strength at centre of ECB policy debate

By Paul Carrel and Anirban Nag

FRANKFURT/LONDON (Reuters) - By expressing concern at the euro's strength, European Central Bank President Mario Draghi is trying to talk down the currency and avoid taking fresh action to tackle worryingly low inflation - but financial markets will test his resolve.

Draghi identified the currency's strength at the weekend as a possible trigger for the ECB to ease policy, saying in Washington: "The strengthening of the exchange rate would require further monetary policy accommodation.

Some analysts say that if the euro rises much further, this would open the way for a significant lurch higher due to a lack of technical resistance. The result would be yet more downward pressure on euro zone inflation, which at 0.5 percent is far below the ECB target of just under 2 percent in the medium term.

The euro is already up nearly 5.5 percent against the dollar over the last year at around $1.38. This strength makes imports cheaper, pushing down the prices consumers pay for goods. While this can give households more purchasing power in the short run, the ECB wants to avoid a drop in inflation expectations.

Such a scenario could result in lower wage agreements and reduced economic demand as households defer purchases, with the nightmare being a downward price spiral similar to the Japanese experience of periodic deflation since the 1990s.

Draghi's emphasis of the euro's strength highlights the impact the ECB believes the exchange rate has on inflation, and focuses attention on the next batch of economic projections from

ECB staff.

In March, the staff forecasts barely saw inflation returning to the target level by the end of 2016 and assumed an exchange rate of $1.36 percent from this year until then. Those forecasts will be updated for the ECB's June 5 policy meeting.

"If they change the assumption to 1.40 that could probably shave 0.1 percentage points off the inflation forecasts and bring additional action closer," said Berenberg bank economist Christian Schulz, adding that "1.40 is a psychological level that will strengthen calls for the ECB to do more".

Draghi was careful at the weekend not to indicate a level at which the ECB would deploy further stimulus. By singling out the exchange rate and stressing their readiness to act if needed, Draghi and his colleagues have capped euro gains for now.

On Monday, the euro retreated modestly from levels close to this year's highs, trading just above $1.3800. The currency is still near the middle of a range it has held since the end of 2003, and a long way off its post-2008 highs of $1.60.

By holding down the euro, Draghi could ease downward price pressures until a stronger economic recovery starts.

"I think maybe the debate is exaggerated a little bit in that we are in a situation where the economic outlook is not so bad," Clemens Fuest, head of Germany's ZEW economic institute, said of the debate about what - if anything - the ECB should do.

MARKET TEST

A stronger inflation reading for April - due on April 30 - could ease the pressure to act. But the ECB must be wary of getting into a tussle with markets if inflation remains low and it does not act.

Traders and strategists say that if the euro rises past $1.40, it could easily touch $1.45 as there is very little technical resistance between $1.40-$1.45.

In the year to date, the euro is up 0.6 percent against the dollar while on a trade-weighted basis, it is up 0.4 percent, building on gains of 5 percent made last year.

"The ECB realises this and wants to keep the euro under $1.40 by talking it down," said a senior trader in London. "But the market will test the ECB's resolve by pushing it higher to see if it will take action. The euro needs action, not just talk."

Some ECB officials say privately they would prefer an exchange rate closer to $1.25. As well as boosting import prices, a weaker exchange rate would help euro zone exports by lowering their cost outside the currency zone.

The euro is being supported by several factors. Investors who have been seeking higher returns outside the currency zone are coming back to bonds and stock markets on the euro zone's periphery as the bloc's crisis subsides.

Also, banks within the bloc are repaying loans they took from the ECB at the height of the crisis, shrinking the central bank's balance sheet at a time when the U.S. Federal Reserve and the Bank of Japan are expanding theirs.

The shrinking balance sheet keeps excess cash on a tight leash and supports short term money market rates. Firm short term rates increases the euro's allure for investors seeking higher yields, especially those from the United States.

Further supporting the currency, euro zone banks have been repatriating money to meet regulatory requirements for higher capital and to pass stress tests this year aimed at ensuring they are strong enough to withstand a future financial crisis.

WHAT TO DO?

The ECB has said it is ready to take fresh policy action if necessary. This could include asset purchases and lowering into negative territory the deposit rate it pays banks for holding their cash. Such a scenario could materialise if Draghi fails to talk down the currency and it rises further.

ECB policymaker Benoit Coeure described on Sunday how the bank would approach an asset purchase plan, stressing that such a programme "would not be about quantity, but about price".

Using such a plan to lower borrowing costs through targeted asset purchases could increase the flow of credit to the economy and stimulate demand, supporting prices.

But the details of the approach Coeure sketched highlight the obstacles the bank would have to overcome. As the Executive Board member responsible for market operations, Coeure would lead such planning.

The fragmented nature of the euro zone economy meant that to achieve reduced borrowing costs by similar amounts across the bloc, the ECB would have to make purchases in different assets in different countries, he indicated.

Furthermore, Coeure said the ECB would have to guard against "operations that unduly distort market allocations".

JP Morgan economist Greg Fuzesi said Coeure's comments show how asset purchases "can very quickly start to look very complex for the central bank, at the extreme with 18 separate purchase programmes tailored to each euro area country".

(Additional reporting by Jan Strupczewski in Washington and Patrick Graham in London; editing by David Stamp)