Central Banks

ECB unlikely to surprise, but deflation concerns grow

The European Central Bank (ECB) is not expected to deploy its "powerful artillery" after Thursday's policy meeting, but economists warn that calls for more action are likely to build, especially given concerns about low inflation and lending.

Economists do not see ECB President Mario Draghi announcing any further rate cuts or stimulus measures, and expect Draghi to adopt a balanced tone at the press conference following the rate decision.

Draghi himself has played down expectations of action at Thursday's meeting, telling German magazine Spiegel that "We don't see a need for any urgent action."

(Read more: ECB'S Draghi sees no urgent need to cut rates further)

Hannelore Foerster | Getty Images

Thursday's meeting comes after the ECB surprised markets in November by cutting its main interest rate to 0.25 percent from 0.5 percent. However, it took no further action in December.

Daiwa Capital Market's Chris Scicluna stressed that little of significance had happened since the ECB met in December, despite the U.S. Federal Reserve's long-anticipated announcement that it would start tapering its bond-purchasing program. He forecast the latest ECB meeting would be, "A low-key affair, with no substantive news on policy and little change to the tone of Draghi's language".

Nicholas Spiro, managing director of Spiro Sovereign Strategy, added that next week, Draghi would "Do what he does best".

"Strike a dovish tone, insist that the ECB still has a 'strong artillery' of policy instruments at its disposal, yet refrain from undertaking further policy action for the time being," Spiro told CNBC.

Lending concerns?

The central bank's case for inaction centers on the signs of a fledgling economic recovery in the euro zone, after its emergence from recession last year.

Recent data point to a gradually improving economic picture. On Monday, Markit's PMI (purchasing managers' index) showed service sector and manufacturing activity in the euro zone expanded once again in December, and at a faster rate than in the previous month.

Meanwhile, data on Wednesday showed euro zone unemployment stabilized in November, albeit at a record high of 12.1 percent. This stabilization has led some economists, including James Howat, European economist at Capital Economics, to conclude the region's labor market downturn is starting to ease.

(Read more: Euro zone manufacturing grows; France stumbles on)

Trade of the day: ECB to ease further in 2014?

"Surveys suggest that the recovery continued in the final quarter, inevitably led by Germany, but with much of the periphery also seeing very modest growth — a situation that hardly lends itself to panic measures," Scicluna added.

However, loan data released last Friday could add to calls for action by the ECB. The figures showed lending to businesses in the euro zone declined by 2.4 percent in November, the fastest pace ever. This followed a decline of 2.2 percent in October.

"Worryingly, there is still no sign of any trend change in bank lending to euro zone businesses, which heaps pressure on the ECB to act," said Howard Archer, chief European economist at HIS Global Insight, in a research note.

(Read more: US vs Europe: Which equities will win in 2014?)

Although Archer did not expect the ECB to announce any further stimulus measures on Thursday, he said he expected the central bank to take action in "The early months of 2014".

Potential action by the ECB could include further "long-term refinancing operations" (LTROs), where it lends money at very low interest rates to euro zone banks, in an effort to boost lending to businesses and consumers. However, Archer and other economists said further operations would most likely be tailored specifically towards boosting bank lending. Draghi has also indicated that government bonds would not be bought by the central bank in the case of a new LTRO.

Deflation risks

Another issue that could spur the ECB to act — although perhaps not next week — is the risk of deflation.

Data published on Tuesday revealed that inflation in the euro zone came in lower than expected in December, adding to concerns that the region could be heading towards a period of deflation. Consumer prices rose by 0.8 percent year-on-year in December, below the 0.9 percent expected by economists and close to October's 47-month low of 0.7 percent which spurred the ECB to cut its main interest rate.

Archer said the inflation figures meant the bank was "more likely than not" to take further action eventually.

"The renewed dip in euro zone consumer price inflation to just 0.8 percent in December is particularly unwelcome news for the ECB as it takes inflation almost back down to the level where the bank felt compelled to cut interest rates," Archer said.

"While the ECB remains adamant that deflation across the euro zone is not a serious risk, it will undoubtedly be uncomfortable with this latest dip in consumer price inflation, which is over a percentage point below its target rate."

Will the ECB take action this year?

However, Spiro said the ECB would likely need more proof that deflation posed a material threat before it eased policy further.

"The gap between what a central bank ought to be doing and what it is unable, or unwilling, to do is the widest in the case of the ECB," he told CNBC.

"The ECB has not only proved conspicuously reluctant to cut rates further, but is internally divided over the further use of non-standard measures."

(Read more: Why euro zone slowdown should worry the world)

Meanwhile, Jonathan Loynes, Capital Economics' chief European economist, warned there was an ongoing factor sustaining deflation risks: the strength of the euro. The euro has risen by over 4.5 percent against the dollar over the last year.

"The euro's strength threatens both to hinder the already fragile recovery in activity and to push inflation further below the ECB's target of below, but close to, 2 percent," Loynes said in a note.

Loynes said this concern, combined with weak economic growth and poor liquidity conditions, could see pressure on the ECB to act build quickly.

"While Mr Draghi will no doubt pay lip service again to his policy artillery (on Thursday), he may choose to keep the powder dry for now," he wrote.

"Quite which weapon the Governing Council might choose to fire will depend on how the situation unfolds… One way or another, though, the ECB surely has more work to do in 2014."

By CNBC's Katrina Bishop. Follow her on Twitter @KatrinaBishop and Google

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