IMF says ECB must expand balance sheet, QE isn't only option

By Leika Kihara

WASHINGTON (Reuters) - The European Central Bank should expand its balance sheet further to stave off the risk of deflation, but options aren't limited to quantitative easing-style purchases of government bonds, a senior International Monetary Fund official said.

Boosting liquidity provision to banks or buying private sector assets like asset-backed securities - even if the pool for them is small in Europe - can also help the region deal with dangerously low inflation, said Mahmood Pradhan, deputy director of the IMF's European department.

Key lessons for the euro area from Japan's experience fighting deflation for nearly two decades is to act quickly, and to look not just at long-term but short- to medium-term inflation expectations, he added.

"The pool of securitized assets in the euro area is quite small. The challenge for the ECB is to expand that pool, which would take time," though it can also include other assets such as corporate bonds, Pradhan, the IMF's mission chief for Europe, told Reuters on Thursday.

"The point is that when you hit the zero lower bound, to maintain an accommodative monetary stance - which in our view is necessary in the euro area - will require expanding the balance sheet. Most unconventional policies we can think of would involve expanding the balance sheet."

The IMF has repeatedly called on the ECB to take unconventional steps to deal with the low level of inflation in the euro zone, which could cripple growth and make it harder for the countries in the region to deal with its huge public debt.

The ECB held off on deploying additional stimulus steps last week but President Mario Draghi flagged the chance of adopting quantitative easing (QE) in the future.

Under QE, a central bank pumps money into the economy via asset purchases, mainly government bonds. Legal constraints make it more difficult for the ECB to buy government bonds compared with the U.S. Federal Reserve and the Bank of Japan.

LESSONS FROM JAPAN

Pradhan agreed with the ECB's view that the euro area is not in deflation, but said there were lessons to be learned from Japan's battle with nearly two decades of grinding deflation.

"Independently of what one might think of the probability or the risks of deflation, inflation is low enough to worry about the adjustment in euro-area economies that have high debt burdens," he said.

"Japan's experience tells us that acting early is really important."

The ECB has responded "quite swiftly" so far but must look at not just long-term, but short- and medium-term inflation expectations in gauging whether price expectations remained well-anchored, he said.

In Japan, long-term inflation expectations were "very well behaved" even when the economy slipped into deflation. But short- and medium-term inflation expectations were giving early signals that inflationary pressures were subsiding, he said.

"We're very interested in looking at the comparison with what's happening in the euro area, where long-term expectations are still well-anchored but short- and medium- term expectations are beginning to show signs of declining."

Japan's experience also shows that solving banking sector problems is crucial for reviving credit growth and support investment, which remains "quite low" in the euro area, he said.

The region's asset quality review and stress tests on banks are steps in the right direction which, once completed, will put Europe in a stronger position to deal with its weak assets, Pradhan said.

"I would like to emphasize that this is an exercise that is quite unique. It's very complex and it's very detailed .... This has not been done before, on this scale, anywhere else."

Euro zone inflation fell to 0.5 percent in March, levels last seen when the economy was deep in recession in 2009 and well below the ECB's target of below but close to 2 percent.

Draghi conceded that low inflation made euro zone debt harder to cut and economic adjustment more difficult - though he has also chided the IMF for making more forceful recommendations to the ECB than it did to the Fed.

(Reporting by Leika Kihara; Editing by Andrea Ricci)