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Disappearing euro zone inflation set to heighten ECB concerns

By Martin Santa and Eva Taylor

BRUSSELS/FRANKFURT (Reuters) - Euro zone inflation dropped to a fresh five-year low in August, data showed on Friday, something likely to concern the European Central Bank but not force it into immediate policy action.

Consumer prices in the 18 countries using the euro rose by just 0.3 percent year-on-year in August, the smallest increase since October 2009, the European Union's statistics office Eurostat said. The number matched market expectations.

The ECB targets an inflation rate at below-but-close to 2 percent over the medium term, a level not seen since the first quarter of 2013. It also considers anything below 1 percent over time to be in a "danger zone".

Inflation moving ever closer toward zero, a stagnating economy, a double-digit unemployment rate and increasing signs of reform fatigue among euro zone governments are posing a tough challenge for the ECB that it says it cannot solve alone.

In a landmark speech at a central banker gathering in Jackson Hole last week, ECB President Mario Draghi said it would be "helpful for the overall stance of policy" if fiscal policy could play a greater role alongside the ECB's monetary policy.

He got backing on Thursday from German Finance Minister Wolfgang Schaeuble, who told Bloomberg that monetary policy could only buy time and had run out of tools, calling instead for more investment without running excessive deficits.

Others believe the ECB should do more to stimulate growth.

"This is yet another bad indicator of the health of the euro zone economy," said Aberdeen Asset Management Investment Manager Luke Bartholomew. "We are now relying on Draghi the politician not Draghi the economist to get Europe out of this mess."

"He is walking a tightrope between conservative European institutions and the markets desire for more stimulus. But as every month passes we get closer to the dread of deflation and Draghi looks more and more like Nero fiddling while Rome burns."

The euro rose to the day's high of $1.3195 as investors trimmed bets against the currency after the data and German Bund futures fell.

The drop in August inflation was led by a 2.0-percent decline in the highly volatile prices of energy. Prices of food, alcohol and tobacco fell by 0.3 percent for a second month in a row in August. Core inflation, which strips out such volatile components, rose to 0.9 percent from 0.8 percent.

"Core inflation resilience at just below 1 percent confirms that outright deflation remains unlikely," said Marco Valli, chief euro zone economist at UniCredit.

In a separate data release Eurostat said that unemployment in the euro zone was, as expected unchanged at 11.5 percent for a second months in a row in July, leaving 18.4 million people without jobs in the 9.6 trillion euro economy.

ONLY WORDS, NO ACTION

Attention now shifts to the ECB's September policy meeting next Thursday where the inflation reading is set to liven up the debate in the Governing Council. Analysts expect a more serious discussion about possible large-scale asset purchases.

Commerzbank now sees a 60-percent chance that the ECB will embark on quantitative easing (QE) in the next 12 months , spending billions of euros on private and sovereign debt to boost growth and inflation, up from an earlier 40 percent.

"QE is now our baseline scenario," said Commerzbank economist Joerg Kraemer, mainly because of the weakening growth prospects for the currency bloc, although he does not expect the ECB to take fresh action on Thursday.

"We expect at best a modification in the wording compared with the August meeting rather than ECB action," he said.

Sources told Reuters on Wednesday that new action on Thursday was unlikely but not impossible. [ID:nL5N0QX47B]

A Reuters poll on Thursday put a 40-percent chance on the ECB conducting QE through the purchase of sovereign bonds by March next year. [ID:nL3N0QY4DR]

ECB policymakers have said in recent weeks the ECB wanted to see the impact of its June stimulus package first before considering further steps. It will offer banks new four-year loans from September and may decide to buy securitised loans.

Expectations the ECB could activate QE, its most powerful tool yet, intensified after Draghi's Jackson Hole speech in which he said financial markets indicated a "significant decline at all horizons" in inflation expectations, adding the ECB would use "all the available instruments" to ensure price stability.

Such a step is, however, highly contested by some ECB Governing Council members, who worry about moral hazard, while others question the effectiveness of such a policy tool that is likely to cost the ECB billions of euros.

(Reporting by Martin Santa and Eva Taylor, Editing by Jeremy Gaunt)

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