President of the European Central Bank Mario Draghi delivering his speech during the Conference ‘ECB Forum on Central Banking’ in Sintra, Portugal, yesterday. Draghi said he expected inflation, which is currently running at 0.7%, to slowly return to the ECB’s target of just under 2%.

Reuters/Sintra, Portugal

The European Central Bank must be “particularly watchful” for any negative price spiral taking hold in the eurozone, ECB chief Mario Draghi said yesterday, adding that the bank was not resigned to inflation being too low for too long.

The ECB is on guard against deflation and ready to act with conventional and targeted measures, while a broad asset-buying plan remains an option, Draghi said.

To guard against a drop in price expectations, “more pre-emptive action may be warranted”, he said in a speech entitled “Monetary policy in a prolonged period of low inflation”.

Draghi’s comments reinforced suggestions from other ECB policymakers that the bank is ready to act at its June 5 policy meeting to counter low inflation and weak lending in the 18-country eurozone.

Draghi said he expected inflation, which is currently running at 0.7%, to slowly return to the ECB’s target of just under 2%.

“Our responsibility is nonetheless to be alert to the risks to this scenario that might emerge and prepared for action if they do,” he said in introductory remarks at the ECB’s new Forum on Central Banking at Sintra in Portugal.

“What we need to be particularly watchful for at the moment is, in my view, the potential for a negative spiral to take hold between low inflation, falling inflation expectations and credit, in particular in stressed countries,” he said.

Setting out policy options for different scenarios, Draghi said that should exchange rate or market developments result in an unwarranted tightening of monetary and financial conditions “this would require adjustment of our conventional instruments”.

Such instruments include interest rate cuts.

Reuters reported earlier this month that the ECB is preparing a package of policy options for its June meeting, including cuts in all its interest rates as well as targeted measures aimed at boosting lending to small- and mid-sized firms.

Draghi indicated that full-blown, US-style quantitative easing — printing money to buy assets — remained an option for the ECB, saying a destabilising of inflation expectations “would be the context for a broad-based asset purchase programme”.

He also fleshed out what he called an “intermediate situation” in which credit supply constraints interfere with the transmission of the ECB’s monetary policy stance.

This referred to the reluctance of banks in some eurozone countries — particularly those on the periphery of the bloc — to issue loans as they repair their balance sheets. The recovery would bring growing demand for credit, Draghi said.

“And at this point, for monetary policy to produce its full effects, there must be no binding constraints on credit supply through the banking system,” he added.

But he warned that credit demand may pick up faster than banks can repair their balance sheets and new capital markets can be developed to complement bank lending.

“If, in this context, availability of term funding is a limiting factor on loan origination, then monetary policy can play a bridging role,” Draghi said.

“Term-funding of loans, be it on-balance sheet — that is, through refinancing operations — or off-balance sheet — that is, through purchases of asset-backed securities — could help reduce any drag on the recovery coming from temporary credit supply constraints,” he added.

These comments suggested the ECB could deploy a long-term lending facility — or LTRO — targeted and providing banks with funds to lend on to businesses and households, or else buy asset-backed securities (ABS) to support the provision of loans.

ECB Executive Board member Yves Mersch said on Saturday that there were signs credit demand in the euro area is beginning to pick up and that banks need to be strong enough to respond to that demand.

Draghi said credit constraints were putting a brake on the recovery in stressed countries while the effects of an appreciating euro exchange rate would hold down eurozone inflation.

“There is a risk that disinflationary expectations take hold”, he said. “This may then cause households and firms to defer expenditure in a classic deflationary cycle.”

Draghi said after the ECB’s May meeting that the Governing Council was “comfortable with acting next time” — its June 5 policy meeting — but wanted to see updated economic projections from the bank’s staff first.

Since then data confirmed a slight increase in eurozone inflation in April to 0.7% from 0.5 the previous month, but it also showed that the eurozone economy grew less than expected at the start of the year.