Central Banks

Why the ECB has to act… versus why it shouldn’t

It all sounds so familiar: yet another low inflation shock in the euro zone increases pressure on the European Central Bank (ECB) to act.

Some economists have been calling on the ECB to pull the trigger at every month since it last cut interest rates in November. But they remain divided as to whether ECB President Mario Draghi will act at this Thursday's monetary policy meeting – or indeed at any time in the near future.

Here's a look at the arguments for and against the ECB intervening.

Ralph Orlowski | Bloomberg | Getty Images

Arguments for…


Fears that the euro zone was sliding towards deflation were ignited in October when data showed inflation had fallen to 0.7 percent - significantly below the ECB's mandated target of just below 2 percent. In response, the bank cut interest rates to a record low of 0.25 percent.

Read MoreEuro zone inflation slides, fueling deflation fears

Economists are concerned about deflation because it can push down demand, as people hold off purchases in the hope of more price declines. This can lead to lower production and an economic slump – something the ECB will want to avoid.

A cut in rates could help the euro zone avoid a slide into deflation by boosting borrowing power and spending. But Draghi and others have stressed that deflation risks in the euro zone are limited.

Nevertheless, economists have argued that March's surprise slide in inflation to just 0.5 percent could spur the ECB to cut yet again.

High euro:

One factor behind this low inflation is a strong euro – which has risen over 2 percent against the dollar over the last six months.

A stronger euro means imports into the euro zone are cheaper, which keeps the prices of products down. But its ongoing strength could hamper the scope for exports to stimulate the euro zone economy, as importers are less likely to pay for high-cost goods.

It appears the ECB is concerned. Last month, Draghi warned that the euro was impacting inflation, and economists have pointed to recent dovish comments by ECB Governing Council members as part of a concerted effort to weaken the euro.

"While talk is cheap, the ECB will ultimately need to back its words with credible measures," Anatoli Annenkov, senior European economist at Societe Generale, said in a note.

Liquidity boost:

A lack of money flowing around the euro zone has hindered the region's recovery. Lending is a sign of a buoyant economy, as consumers and businesses feel confident enough to borrow – and spend.

ECB to get drastic? QE could be on the table

The ECB has already attempted to boost liquidity by offering ultra-cheap, long-term loans to banks, but tight monetary conditions have persisted.

In February, however, lending to the private sector in the euro zone fell 2.2 percent in February from the same month a year earlier, after falling 2.3 percent in January, which IHS Global Insight's Chief European Economist Howard Archer described as "worrying,"

He argued that if and when the ECB did act, it would most likely include measures aimed at adding liquidity.

ECB rate cut coming, just not next week: Pro

Arguments against…

Improving economic conditions

Recent data have boosted hopes that the euro zone's recovery is taking hold, with gross domestic product beating expectations to grow by 0.3 percent in the fourth quarter of 2013.

Unemployment figures released Wednesday added to this positive sentiment, with data showing that unemployment fell by 35,000 in February.

"Macro data released since the last ECB meeting in March has shown that the recovery is not only on track but is also more robust than previously thought," Carsten Brzeski, senior economist at ING, said in a note. "In short, the economy is doing exactly what the ECB had expected."

Draghi has said the ECB needs more information on the recovery before intervening, and signs of improvement could relieve some pressure to act.


Another theory is that the ECB never planned to ease policy at all. Instead, the ECB could be hoping that carefully-planned communication is enough to control conditions in the euro zone -- something Brzeski describes as "talking the talk in order not to have to walk the walk."

Read More IMF calls for ECB action: What are Draghi's options?

"This plan would be to make extensive use of aggressive communication only, hoping for the dollar to strengthen and for euro zone inflation to pick up finally from April onwards," Frederik Ducrozet, senior euro zone economist at Crédit Agricole, said in a note.

Stand by for the bazooka

Alternatively, the ECB could be holding fire in anticipation of using its "bazooka". Draghi has repeatedly said there are multiple policy tools at the ECB's disposal, and some of the more unconventional measures have recently garnered attention.

Last week, Germany's Bundesbank President Weidmann stoked interest by telling newswire MNI that bond-buying, or quantitative-easing (QE), had not been ruled out.

Such a measure would be a drastic change in policy. Indeed, the move could be so drastic that the ECB could be storing it up for a crisis point.

"We've been pushing the idea that they should - and may well - do it (QE)," Loynes told CNBC, adding: "We would actually prefer QE because it's the only powerful tool left in the ECB's locker."

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