By Balazs Koranyi and Francesco Canepa
FRANKFURT (Reuters) - European Central Bank President Christine Lagarde took a modestly upbeat view on Europe's recovery from a historic recession on Thursday and played down concerns about the euro's strength, disappointing hopes she would signal more stimulus.
While warning that a second wave of coronavirus infections represented "headwinds", Lagarde announced a slight upgrade in the bank's 2020 growth forecast on the back of a strong rebound in activity and signalled higher underlying inflation.
She also a took a benign view on the currency, simply saying the bank would "monitor carefully" exchange rate movements. This was seen by some analysts as the weakest possible expression of concern after the euro rose 8% against the dollar this year, weakening both growth and inflation.
"Clearly to the extent that the appreciation of the euro exercises negative pressure on prices, we have to monitor carefully such a matter, and this was extensively discussed in the Governing Council," Lagarde told a news conference after the ECB left policy unchanged.
Investors had expected tougher language, so the euro actually firmed by half a percent on her comments as the ECB appeared keen to avoid a currency war.
Sources on the ECB's rate-setting Governing Council said they chose such a formulation because they judged that the currency was broadly in line with economic fundamentals and they feared any hint of a "currency war" with the United States.
While the strong euro is indeed a drag, some argued that the $1.20 level, seen in the past as a key threshold, is now close to the equilibrium exchange rate and should not be seen as trigger level for the ECB, the sources added.
The measured view on the exchange rate and the upgrade to growth also tempered hopes about a further expansion of its 1.35 trillion euro emergency bond buying scheme, which most economists expect to be extended later this year.
"The surprise came from a series of communication changes suggesting that the central bank is not about to ease policy immediately," Pictet Wealth Management Strategist Frederik Ducrozet said.
But he added: "The reality of weak growth and disinflationary pressures will ultimately force the ECB to increase its Pandemic Emergency Purchase Programme by 500 billion euros in December."
"EFFICIENT AND EFFECTIVE"
Asked about a possible change in policy, Lagarde said council members believed that existing measures were both "efficient and effective" and likely to be used in full.
But she refrained from any hints that could be taken as a signal the ECB would eventually expand stimulus.
"Under current circumstances it is certainly very likely that the full envelope of PEPP will be used," she said of the 1.35 trillion euro Pandemic Emergency Purchase programme. She added later that no change to PEPP had been discussed.
Markets nevertheless continue to expect the ECB to add to its bond buys, not least because euro zone governments will need to borrow heavily next year to keep their economies afloat. That will increase bond issuance, so any suggestion the ECB is stepping back from the market could push borrowing costs higher.
And even if the bloc's coronavirus recession is not as deep as feared, it will still take until the end of 2022 for economic activity to fully recover.
Indeed, despite the improved outlook, the ECB still expects output across the 19 countries that use the euro to shrink by 8% this year before expanding 5% next year.
"Make no mistake: around the turn of the year, the ECB is likely to relax its monetary policy further -- and all the more so if the euro continues to appreciate," Commerzbank economist Joerg Kraemer said.
(Writing by Mark John; Editing by Catherine Evans)