Slump in euro zone money supply growth highlights deflation risk

FRANKFURT Wed Jan 29, 2014 5:19am EST

(Reuters) - Euro zone money supply growth slowed sharply in December and loans to the private sector contracted further, putting pressure on the European Central Bank to take fresh action to counter the threat of deflation.

With euro zone inflation running well below its target, the ECB forcefully underlined its determination earlier this month to take action should a deflation risk arise or rising money market rates threaten the bloc's fragile recovery.

Data released by the ECB on Wednesday showed that euro zone M3 money supply - a general measure of cash in the economy - grew at an annual pace of 1.0 percent, slowing markedly from 1.5 percent in November.

"The weakness of the monetary aggregates remains a warning sign that the fight to ward off deflationary pressures has not been won yet," said ING economist Peter Vanden Houte.

"Moreover, with credit growth remaining constrained, the risks to the recovery remain."

The ECB has cut interest rates to a record low, pumped extra liquidity into the banking system and announced a fresh government bond purchase program, but the measures have so far not managed to unclog lending to the real economy.

Wednesday's data also showed that loans to the private sector shrank by 2.3 percent in December from the same month a year earlier. That compared to a contraction of the same amount in November.

"There remains considerable pressure on the ECB to come up with concrete measures aimed at improving credit availability to companies, especially small and medium-sized ones," said Howard Archer, economist at IHS Global Insight.

Lending to firms fell by 2 billion euros from the previous month, much less than the 14 billion euro drop in November.

One factor which could have suppressed lending late last year is the upcoming bank health review.

Before the ECB starts supervising banks in November of this year, it will run a series of tests on the euro zone's largest lenders to uncover potential balance-sheet risks and capital shortfalls.

The asset-quality review is based on banks' balance sheets at the end of 2013. ECB policymakers have admitted that could have crimped lending in the final months of last year.

After the bank's January 9 policy meeting, ECB President Mario Draghi identified two scenarios that could trigger fresh policy action: an increase in money market rates that tightens policy by stealth, or a deterioration in the inflation outlook.

Euro zone inflation is running at 0.8 percent, far below the ECB's target of just under 2 percent, but the bank appears content to sit on its hands in the hope recovery unfolds.

Although inflation is low, ECB officials appear comfortable enough for now with the policy-relevant medium-term outlook, and the money market red flag is not waving vigorously enough to worry them.

But the weak lending data highlights the anemic nature of the recovery and will keep up pressure on the ECB to act.

Draghi said in Davos, Switzerland last week that the ECB could potentially buy packaged bank loans if such asset-backed securities (ABS) were more transparent.

Global Insight's Archer saw a "distinct possibility" the ECB could eventually take further action in the form of a new LTRO long-term funding operation for banks tailored towards lending to the private sector.

"Very low and reduced money supply growth in December indicates that underlying euro zone inflationary pressures remain muted and very much keeps open the possibility that the ECB will end up taking further stimulative action," he said.

ECB Governing Council member Klaas Knot said at the weekend that were the ECB to offer more cheap long-term loans to banks, he favored attaching conditions, although he added there was no need for them at this point.

(Writing by Paul Carrel; Editing by Catherine Evans)