ECB to cut inflation forecast but keep powder dry

By Balazs Koranyi

FRANKFURT (Reuters) - The European Central Bank is set to cut its inflation forecasts on Thursday because of falling oil prices and China's economic slowdown, and it will probably promise to beef up its bond- buying programme if prospects weaken further.

The bank is expected to leave interest rates unchanged and argue that the chance of missing its medium-term inflation target has increased but the time is not yet right to take concrete policy action. It is also likely to say its $1 trillion euro plus asset buying programme is working, albeit slowly.

The ECB launched the 60 billion euro (44 billion pounds) per month asset-buying programme in March to boost consumer prices after a short bout of deflation.

But nearly all key price drivers have been working against its efforts to bring inflation, now running at 0.2 percent, back to its target of just under 2 percent.

Oil prices are down 35 percent since May, iron ore is near an all-time low, the euro has unexpectedly firmed and Chinese growth, already a worry for the ECB in July, is slowing sharply. One of the bank's favoured gauges of inflation expectations, the five-year, five-year euro zone breakeven forward (EUIL5YF5Y=R), has fallen to 1.7 percent from 1.85 percent in July.

Indeed, a majority of analysts polled by Reuters expect the bank to eventually extend or increase its quantitative easing programme. Three quarters said that the bank has simply run out of tools and that adjusting QE, expected to run until next September, was its only viable option.

"The economic benefits of the ECB’s QE programme are fading, inflation expectations are low and global growth is under threat from a rapidly slowing Chinese economy," RBS said in a note to clients.

Peter Praet, the bank's chief economist, has said markets should not doubt the ECB's "willingness and ability" to act. But comments from other rate setters like Benoit Coeure and Vice President Vitor Constancio suggest the bank will want to take time before taking action and prefers steady policy for now.

The ECB will also argue that the drop in oil prices will impact inflation only temporarily and while near-term forecasts are cut more, the impact on 2017 inflation, earlier seen at 1.8 percent, will be more limited.

"Given the increasing uncertainty surrounding China, the ECB’s wait-and-see mode will likely be characterized by heightened alertness to external events," UniCredit said.

"We expect ECB president Mario Draghi to respond to this more challenging environment with a strong commitment to further easing if price stability were to appear threatened, it added.

The ECB will also be keen to highlight some of the positive impacts of QE, even as inflation has stayed below 2 percent since early 2013.

Lending to euro zone firms in July grew at the fastest pace since early 2012, unemployment fell and the composite purchasing manager's index unexpectedly rose, offering a glimmer of hope that growth may be picking up, even after a lacklustre second quarter.

The bank may also argue that the impact of China's market volatility on the euro zone is limited and the moderate rise in yields on the euro zone's periphery amid the market rout shows that the bloc is in better health than at any time in years.

(Additional reporting by John O'Donnell and Francesco Canepa; Editing by Hugh Lawson)