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Here’s the key challenge Draghi will face at this week’s ECB meeting

Rising oil prices may see the European Central Bank (ECB) upgrade its inflation forecast when it meets on Thursday, while striving to keep the door open for further monetary policy loosening if necessary.

"Given the recent oil price rise, a key question is to what extent the ECB will raise its inflation projections for 2016-2018 and what this might signal for its QE (quantitative easing) policy after March 2017," UBS economists said in a report on Thursday.

European Central Bank President Mario Draghi.
Emmanuel Dunand | AFP | Getty Images
European Central Bank President Mario Draghi.

ECB President Mario Draghi will need to tread a careful line after some upbeat data this month. A flash official estimate showed euro zone economic growth averaged a seasonally adjusted 0.5 percent in the first quarter of the year, versus the previous quarter. This marked a gentle acceleration from the previous year, when growth averaged 0.3 percent in both the third and fourth quarters.

Plus, the European Commission reported on Monday that its economist sentiment indicator increased in the euro area by 0.7 points to 104.7 in May.

Meanwhile, a two-month upturn in oil prices saw Brent and WTI crude oil top $50 per barrel on Thursday and remain above $49 on Friday and Monday.

However, overall inflation remains very low and the euro area slipped back into deflation in April, with prices declining on the year by 0.2 percent.

"We think the key challenge for Mr Draghi will be to not appear too hawkish amid rising oil prices and robust euro zone (first quarter) GDP (gross domestic product) growth," UBS said.

Jack Allen, a European economist at Capital Economics, concurred.

"The ECB is likely to maintain a dovish tone at its meeting on Thursday, holding the door open to further policy loosening later in the year," he said in a report on Friday.

On Wednesday, Fitch Ratings increased its growth forecast for the euro zone by 0.1 percent to 1.6 percent. It said household spending was supported in the 19-country currency union by labor market improvements, continued growth in bank credit — and low headline inflation.

The ECB held monetary policy unchanged last month, with the main refinancing interest rate at 0.0 percent, the deposit rate at -0.4 percent and its monthly asset purchases at 80 billion euros ($89 billion).

This followed the surprise announcement of new stimulus measures in April. These included an increase in the ECB's monthly asset purchases and an extension in the program to include corporate bonds from June.

From next month, UBS estimates 1,289 corporate bonds with an outstanding value of 756 billion euros will be eligible for purchase. In a report on Friday, the bank suggested 12 billion euros or 15 percent of the ECB's total monthly purchases would be corporate bonds, with a split of around 30:70 between the primary and the secondary market.

UBS said the impact on corporate bond pricing would be "negligible."

The purchases will be carried out on the ECB's behalf by the national banks of Belgium, Germany, Spain, France, Italy and Finland. They will take place in both the primary and secondary markets. To be eligible, instruments must be denominated in euros and have a credit rating of at least "BBB-" or equivalent; they must also have a remaining maturity of between six months and 30 years at the time of purchase.

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UBS said that at Thursday's ECB media conference, Draghi would likely avoid any guidance on whether asset purchases would extend beyond March 2017 — the earliest date at which the ECB has said it will halt the program.

"From today's perspective, it seems unlikely to us that QE (quantitative easing) will come to a sudden stop in April 2017," the bank's economists added.

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