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Euro strength puts pressure on Draghi as ECB meets

The euro is likely to be in focus at this week's European Central Bank (ECB) policy meeting, as a new wave of currency strength threatens to undermine the central bank's efforts to boost inflation in the euro zone.

The ECB will hold its regular meeting and news conference on Thursday and while no major policy changes are expected to be announced by the central bank's President Mario Draghi, he is likely to stress further support in the future is possible, according to analysts.

Read MoreLow oil prices drag on Euro zone inflation

Mario Draghi, President of the European Central Bank (ECB).
Daniel Roland | AFP | Getty Images
Mario Draghi, President of the European Central Bank (ECB).

Amid heavy selling in risk assets related to China economy concerns and expectations of an interest rate rise in the U.S., investors have viewed the euro as a "safe-haven asset" – piling into the currency in recent weeks. A stronger currency puts downward pressure on inflation in the euro area and threatens to undermine exporters, creating a headache for ECB policymakers.

"The sharp appreciation of the euro exchange rate, which is related to fears about China and associated weakening of expectations for interest rate hikes by the U.S. Federal Reserve, has added to downside risks to inflation and economic activity," Jennifer McKeown, senior European economist at Capital Economics said.

"We think that inflation will be much weaker, averaging perhaps -0.1 percent this year and rising to only 1.0 percent by 2017," she said.

The euro was trading at $1.128 on Wednesday, below last week's high of $1.1715, but still up some 2.4 percent for the month of August. That's up more than 12 percent from a 12-year low against the dollar hit below $1.05 in March just ahead of the ECB's bond buying program.

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Inflation downgrade

Inflation in the 19-country euro zone is currently at 0.2 percent year-on-year and concerns about deflation have prompted the ECB to start buying 60 billion euros worth of assets a month.

Since the central bank's last gathering in July, financial conditions have tightened, meaning liquidity in financial markets has dried up and the currency bloc's inflation outlook has worsened, following renewed strength in the euro and the continued weakness seen in oil prices.

Read MoreWhat happened to oil's bounce?

As a result, the ECB is likely to cut its inflation forecast for the year after its governing council meeting this week. Capital Economics expects the ECB to lower its inflation forecast by about 0.3 percent to about 0.0 percent this year, while the forecasts for 2016 and 2017 should be little changed at about 1.5 percent and 1.8 percent respectively.

"We expect President Draghi to maintain an accommodative stance during his introductory statement, likely insisting that the Governing Council still has tools available should monetary and financial conditions tighten further," chief European economist at Barclays, Phillipe Gudin, said in a note to clients on Tuesday.

Options

The ECB's chief economist Peter Praet, who is also a member of the ECB's executive board, said last week that falling commodity prices and a slowdown in China were hindering the central bank's goal of getting inflation back up to around 2 percent and pledged the bank would do more if necessary.

In the face of continued weakness and the heightened risk of deflationary shocks, there are three main options for additional policy support according to analysts. The ECB could cut interest rates again, increase the size of its monthly asset purchases, or extend the program beyond the current scheduled end date of September 2016, they said.

But further cuts to the deposit rate, which is already at -0.2 percent, would risk having negative consequences, including the prospective damage to banks' profitability, which could cause them to cut their own deposit rates or increase lending rates, moves that would likely hurt the growth of businesses in the euro zone.

Read MoreEuro zone unemployment hits 3-year low - but don't get out the flags yet

"Governing Council members have already indicated quite strongly that short-term policy rates have reached a floor. Accordingly, we expect hints of potential future policy support to centre on the Asset Purchase Programme," said McKeown at Capital Economics. She expects the ECB to extend its QE program beyond next year and probably increase the pace of purchases in the meantime.

Barclay's Gudin agreed. "We now expect further easing to be announced before year-end as we believe inflation is unlikely to return to levels consistent with the ECB's objective of price stability over the next two years," he added.