Attention has turned to the European Central Bank's (ECB) monetary policy meeting on Thursday as several analysts warn that the central bank runs the risk of making the same mistake that the Bank of Japan (BOJ) has made in the past by downplaying a deflation threat.
Back in the late 90's, the Japanese central bank failed to curb a trend of falling prices that would go on for years. The BOJ ultimately introduced quantitative easing but many analysts remain unclear about its effectiveness and the measure might be seen as more of a last-minute step that keeps market rates low.
The better option for the ECB would be to get ahead of the curve, and although it is running out of conventional options, may need to take important steps now before the deflation threat becomes more imminent. That is why this month's monetary policy meeting is so important.
Citing reports from several investment banks, Reuters listed some of the similarities between the European Union (EU) and Japan, including a weak economic expansion after a series of shocks, a reluctance by banks to lend, a rising exchange rate, and a debatable monetary-policy stance.
However, ECB Governor Mario Draghi's remarks suggest that the similarities stop there as medium-term inflation expectations remain anchored at the ECB's target of just below 2%. Draghi admits that inflation will remain "low for an extended, protracted period of time" but he expects economic growth and a higher global inflation to bring prices up.
The Governor argues that weaknesses are pervasive in some nations - such as Greece - that must restore domestic imbalances and gain competitiveness. In this regard, and unlike Japan, the EU has the added problem of market fragmentation, which makes monetary policy less effective, and which the EU has arguably been slow to address. Solutions may have to come from a larger policy framework that could be offered through a banking union.
About a quarter of forecasters in a Bloomberg News survey say the ECB will reduce their benchmark interest rate from a record-low 0.25%. Other options include cutting the deposit rate into negative territory and not sterilising the Bank's bond purchases.
According to Reuters, an ECB source predicted there would be unanimous agreement to end sterilisation of the bond purchases made under the bank's Securities Markets Programme (SMP).
"The resultant release of around €175bn ($242bn) would roughly double the amount of excess liquidity in the euro zone financial system, help bring down interbank lending rates, and could also lower the euro's exchange rate
against the dollar," the news agency cited.
However, it is likely that Germany's Bundesbank would prefer an interest rate cut since the SMP was a controversial programme in the first place and would again raise the issue about the legality of debt monetization.
The 'negative deposit rate' option has gained some traction within the ECB, however, it carries risk and it's effectiveness is questioned. The ECB may not be ready to take this route although it has considered in the past a minor cut to -0.1%.
With the ECB monetary policy meeting looming, investors will be placing their bets as to whether the central bank will decide to act. Draghi has brought special attention upon this meeting, suggesting that the 'wait and see' period will be over by then and that he will have the necessary information, in particular staff forecasts extending into 2016. In fact, the latest ECB monthly bulletin revealed a 1.9% inflation forecast for 2016 ,according to the latest round of surveys, which may be low enough to pass one or more of the preventive measures against deflation.