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Euro falls as ECB expected to cut inflation outlook

European Central Bank (ECB) President Mario Draghi
Sean Gallup | Getty Images
European Central Bank (ECB) President Mario Draghi

The euro has fallen more than 0.6 percent against the dollar as investors anticipate a cut in inflation forecasts when the European Central Bank (ECB) meets on Thursday.

The euro zone currency dropped as low as $1.1205 Wednesday morning after Bloomberg reported that the ECB will cut its inflation forecast for 2019. It was trading at $1.1264 prior to the announcement, having closed at $1.1268 on Tuesday.

Though interest rates are expected to remain unchanged when the central bank holds its latest monetary policy meeting, the drop preempts a likely shift in the language used by the bank to assess upcoming economic risks.

The report, which was attributed to unnamed euro-area officials, suggests that the ECB will show consumer-price growth falling to around 1.5 percent over the next three years, down from March predictions which estimated growth of between 1.6 percent and 1.7 percent.

Market watchers will be waiting to hear how these draft projections correspond when President Mario Draghi and his team make their latest announcement in Tallinn tomorrow.

They have a fine line to tread: while economic data suggests that the euro zone economy is doing much better than expected, inflation is still not close to their target of below but close to 2 percent.

"The Council sounds confident enough to upgrade the balance of risks to growth, but the conviction in inflation is not there yet, with the May flash inflation print doing nothing to change this," Mark Wall, chief economist at Deutsche Bank Research, said in a note.

"However, we would still expect some soft exit expectations management, for example, talking up economic growth and tasking the internal committees to consider the options for forward guidance, deposit rate and QE (quantitative easing)."

Economic growth in the euro zone was almost twice as fast as it was in the U.S. in the first quarter of 2017, raising the question whether more stimulus was required as the recovery appears to be self-sustaining.

"The upswing is becoming increasingly solid, and continues to broaden across sectors and countries, " Peter Praet, the ECB's chief economist, said in a speech May 24.

"The dispersion of growth rates across both countries and sectors is at its lowest level in two decades, reflecting a convergence of growth rates around higher levels," he added.

But before getting carried away by economic optimism which would vindicate a rather sooner than later exit from extraordinary measures, the real driver for the monetary policy setters at the ECB is inflation.

Inflation in the euro zone slipped to 1.4 percent in May, its lowest reading since December, and also more than expected. So-called core inflation - stripped of energy and unprocessed food prices - also fell to 1 percent from 1.2 percent. This is clearly supporting the doves in the Governing Council who call for longer than shorter stimulus.

At the upcoming meeting in Tallinn, Estonia, the ECB will also present a new round of staff projections for inflation and growth.

"There is some uncertainty over how the new euro system staff projections could change," writes Anatoli Annenkov of Societe Generale in a note.

"While the economy is doing rather well, the Governing Council has been clear that it considers the previous wage assumptions as high, given the uncertainty over the slack in the labor market. With lower wage growth and a slightly stronger exchange rate assumption, there is likely room to reduce the 2019 inflation forecast somewhat."

This is why the ECB currently is caught between a rock and a hard place. With inflation not credibly close to its target, the ECB cannot start the real exit process even though calls for an end are getting louder and louder.

When it comes to the real "taper", those who were expecting action this year, are bound to be disappointed.

"We expect the ECB to continue buying assets into 2018," said Jack Allen of Capital Economics, in a note.

"We think that it will spell out in September its plan to taper QE. This seems most likely to mean reducing purchases by 10 billion euros ($11.26 billion) each month, starting in January 2018. This would bring them to an end by June."

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