LONDON, Nov 7 (Reuters) - An alarming drop in euro zone inflation - to 0.7 percent from 1.1 percent - throws today's European Central Bank policy meeting into very sharp relief. Not since the central bank cut interest rates in May has it been under such scrutiny.
No policy change is likely, and 'sources familiar' are already talking down the threat of deflation. But the central bankers, who are mandated to target inflation at close to 2 percent, will be alarmed at the sight of price pressures evaporating. One need look no further than Japan to see the damage deflation can do, often for many years.
We reported last week that a strengthening euro has also come onto the ECB's radar, given it could depress both growth and inflation, and that there are three camps - one wanting an interest rate cut (which we know was discussed at the last meeting), another preferring to keep the option open of another long-term liquidity flood for the banking system as was done last year, and a third wanting to do nothing.
The euro has since dropped quite sharply, it should be noted, but unless inflation starts picking up a little, the likelihood of some action before long grows significantly. Our latest poll of 59 economists predicted the ECB would inject more liquidity into the banking system, probably early next year.
That was conducted before the last inflation figures came out and the odds on a rate cut to 0.25 percent are now tumbling fast. The December meeting, when the ECB will produce updated growth and inflation forecasts, is a more likely date.
Today, expect Mario Draghi to indulge in some robust verbal intervention - warning that he and his colleagues stand ready to act and still have an arsenal at their fingertips.
He has not tended to indulged in the coded wordplay of his predecessor, Jean-Claude Trichet, but watch out for a dusting off of the 'strong vigilance' phrase which in years gone by indicated a rate move slightly further down the road (though in Trichet's days it signalled a rate rise not cut).
Ta Da, here comes the euro zone's good news story. The European Union and International Monetary Fund are due to sign off on the last part of a 85 billion euro bailout, leaving Ireland to exit the process by the end of the year, the first euro zone country to do so.
The remaining question is whether to take out an insurance policy of a precautionary credit line when the bailout ends. Dublin has indicated in recent weeks it may not as it has funding in place into 2015. If so, it also sees itself in no need of possible bond-buying support from the ECB (which would probably not have been forthcoming anyway).
Italian Prime Minister Enrico Letta is in Dublin for talks with Enda Kenny.
There's a big story breaking in Russia with the Economy Minister saying the country will perform far worse than expected all the way up to 2030 - averaging growth of 2.5 percent.
That is puny in emerging market terms and is a shadow of the government's former forecast of 4.3 percent. This is tantamount to saying the Russian model, heavily reliant on energy and mineral resources, is broken. Could it be the wake-up call the Kremlin needs to push through serious structural reforms?
The Bank of England also holds its monthly policy meeting. It is looking at a very different vista to the ECB - an economy recovering robustly and inflation well above its two percent target.
No change in policy will be forthcoming and the focus will again be on the Bank's forward guidance that interest rates are unlikely to rise until late 2016 because unemployment will only fall to 7 percent and below very slowly.
The consensus is that the jobless rate will get there in late 2015 or even sooner and that Mark Carney will eventually have to acknowledge that and shift the Bank's guidance. Not yet though. For now Reuters polling produces a median forecast of an April 2015 rise in rates from a record low 0.5 percent. A minority expect a move before the end of next year.
French and Spanish bond auctions should be routine but the story of the week here was the bumper demand Italy attracted for its new inflation-linked 'BTP Italia' retail bond. Previous such issues have sailed out of the door this year but this surpassed all expectations with 22 billion euros being raised, making it the biggest single bond sale by a European government and all but meeting its remaining 2013 funding needs.
That lack of market stress is another factor which gives the ECB some time to weigh its options.
Spain, which has basically met its 2013 funding requirement, will offer up to four billion euros of five-, 10- and 13-year bonds. France is aiming to sell up to 6.5 billion euros of 10- and 31-year bonds. After the runaway success of Italy's retail bond the direction for peripheral yields appears to be downwards.
(Editing by John Stonestreet) Keywords: EUROPE/VIEW
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