European Central Bank needs to guard against 'negative spiral' of low inflation that could drag down economy, is prepared to engage in large-scale bond purchases to fight low inflation, deflation, says ECB President Draghi

Cindy Allen

SINTRA, Portugal , May 26, 2014 (Associated Press) – European Central Bank President Mario Draghi said the bank needed to be on its guard against a "negative spiral" of low inflation that could drag down the economy — and it could engage in large-scale bond purchases to combat that if need be.

Draghi's remarks at a conference in Sintra, Portugal, held out the prospect for action to stimulate the weak recovery at the ECB's next governing council meeting June 5.

The meeting will take place against the background of a slow recovery in the 18 countries that share the euro currency and concern that Europe may fall into outright deflation, or a crippling downward price spiral.

Most economists think the bank will take some kind of action at the June meeting, probably cutting its benchmark interest rate from what is already a record low of 0.25 percent. That would marginally reduce the cost of credit when banks borrow from the ECB, in hopes they would pass such lower rates on to business and consumers.

The ECB could also impose a negative interest rate on money that banks deposit with it, pushing them to lend it instead of hoard it.

Yet Draghi focused on other measures in his speech, talking about ways to improve the flow of credit to small companies in countries still recovering from troubles over too much government debt.

One tool available to the ECB would be to make more cheap credit available to banks, so that they could lend it on to businesses. Or, the bank could purchase securities based on loans to small companies, an indirect way of making money available through financial markets. He said that a quarter of viable companies in Spain and a third in Portugal were finding it hard to get credit.

He also said the ECB could use broad-based purchases of financial securities if inflation remains low for too long. Currently, inflation is only 0.7 percent, below the bank's goal of just under 2 percent. The U.S. Federal Reserve has made purchases of government and mortgage-backed bonds to increase the supply of money in the economy and promote growth and employment.

The ECB has, however, held off and many economists remain skeptical the bank will actually engage in large-scale purchases. Such as step would face practical, political and legal complications in the eurozone because it has 18 member countries. That raises the question of which countries' bonds to buy, and whether such purchases would take the pressure off individual governments to reform their economies and finances.

Draghi said that an unexpectedly long period of low inflation could make it harder for indebted countries and companies to work off debt. That could lead firms to reduce investment and consumers to spend less, causing "a pernicious negative spiral, which then also affects expectations," he said.

A too-prolonged period of low inflation "would call for a more expansionary stance, which would be the context for a broad-based asset purchase program."

The eurozone economy grew just 0.2 percent in the first quarter compared with the previous three months, and unemployment is high at 11.8 percent.

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McHugh contributed from Frankfurt, Germany.

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