Mario Draghi is facing down a deflation threat with few optionsleft to fight it.

Consumer prices in the euro area are rising at the slowest pacein four years, well below the European Central Bank's (ECB's)target of just under 2 percent. The ECB president has a choice ofcutting rates that are already near zero, injecting liquidity thatmay not boost prices, or ignoring the ECB's own definition of pricestability, according to banks including JPMorgan Chase & Co.and BNP Paribas SA.

A price slowdown could turn into a negative spiral that derailsthe recovery in the euro region. While the 17-nation economy exitedsix quarters of recession in the three months through June, itstill has record unemployment and shrinking bank lending.

“The ECB has become unusually tolerant of low inflation, even byits own standards,” said Greg Fuzesi, an economist at JPMorgan inLondon. “The argument for inaction is becoming more stretched,however. The refinancing rate cut is the simplest option in thenear term.”

Euro-area inflation slowed to 0.7 percent in October, the lowestlevel since November 2009 and the ninth straight month that therate has been less than the ECB's ceiling, European Union datashowed yesterday. Price gains are sluggish amid a fragile recoveryand a strengthening euro that cuts the price of imports.

Rate-Cut Predictions

The euro depreciated 0.7 percent to $1.3493 today, headed forthe biggest weekly slide against the dollar since July 2012. Germantwo-year yields dropped to 0.11 percent, the lowest level sinceJuly this year. Benchmark 10-year bund yields rose to 1.697 percentafter falling to 1.65 percent yesterday, the lowest level sinceAug. 8.

The report prompted speculation the ECB will invoke policiesfrom a reduction in its benchmark interest rate, currently at arecord low of 0.5 percent, to adding fresh liquidity to thefinancial system, or broad-based asset purchases similar to thoseby the U.S. Federal Reserve.

Bank of America Corp., UBS AG, and Royal Bank of Scotland GroupPlc now forecast a rate cut at this month's meeting on Nov. 7. BNPParibas, Societe Generale SA, JPMorgan Chase, ABN Amro Bank NV,Nomura Holdings Inc., and Scotiabank predict a reduction inDecember, when the central bank will publish new economicprojections.

Inflation Undershoots

“Inflation is persistently undershooting the ECB's definition ofprice stability, which risks unanchoring inflation expectations onthe downside,” said Ken Wattret, chief euro-area economist at BNPParibas in London. In addition, “the appreciation of the exchangerate is leading to an inappropriate tightening of financial andmonetary conditions in the euro area.”

So far, Draghi has held his nerve when it comes to the threat ofdeflation. Judged by their actions, ECB policy makers are now moresanguine about price gains well below 2 percent than in the past.Even though the central bank forecasts inflation will average 1.3percent in 2014, it hasn't signaled that's low enough for it to cutrates.

Neither has the ECB indicated it'll act to halt a rising euro.The single currency has appreciated more than 4 percent against itsmajor peers since late March and rose to a two-year high againstthe dollar last week.

An appreciation of 10 percent in trade-weighted terms has thesame effect as an interest-rate increase of 0.5 percentage point to1 percentage point, according to calculations by Nordea Marketslast month. Erik Nielsen, chief global economist at UniCredit SpAin London, said such a gain would shave off 0.8 percentage point ofgross domestic product over two years, with most of the impact inthe first 12 months.

The ECB has warded off calls for U.S.-style quantitative easingand opted instead to provide banks with unlimited cash for as longas three years. The euro-area economy relies on bank lending forabout 70 percent of credit, making asset purchases a more difficultpolicy tool to use. Securities account for about 70 percent offinancing in the U.S.

Draghi may simply wait for the nascent euro-area recovery tolead to an acceleration in price gains. Business confidence asmeasured by the European Commission increased for a sixth month inOctober to the highest level in more than two years, whilemanufacturing and services output has expanded since July,signaling the recovery in the euro area is gaining strength.

Low inflation may even help growth, according to Christoph Weil,an analyst at Commerzbank AG in Frankfurt. Periphery nations arecutting labor costs as they strive to reduce a euro-regionunemployment rate that stood at 12.2 percent in September.

“The low rate of inflation is a positive sign, as it is largelydue to weak price pressure in the crisis countries,” Weil said.“Declining prices in Greece and Spain confirm that companies areusing the drop in unit-labor costs to improve their pricecompetitiveness.”

Draghi has sent mixed signals on how to handle consumer prices.In June, when annual gains were averaging 1.6 percent, he said lowinflation is not necessarily bad. “With low inflation, you can buymore stuff,” he said. A month later, he reiterated that “pricestability goes in both directions,” signaling that undershootingthe ECB's target is just as dangerous as exceeding it.

Northern Resistance

“We expect headline inflation to fall further in the comingmonths, which would leave the single currency area vulnerable to adeflationary episode in the case of a negative demand shock,” saidNick Kounis, head of macro research at ABN Amro in Amsterdam. “ANovember move is possible but not probable, given that there isstill resistance by officials from some of the northern memberstates. They and the rest of the council will probably want to waitfor the updated inflation projections in December.”

Bundesbank President Jens Weidmann has warned repeatedly thatinterest rates kept too low for an extended period carry risks thatare hard to gauge. Ewald Nowotny, Austria's representative on thecouncil, said in an interview with Market News Internationalpublished on Oct. 29 that policy makers are unlikely to cut theirbenchmark or the deposit rate.

“Draghi has to have a higher tolerance for low inflation,” saidCarsten Brzeski, senior economist at ING in Brussels. “He canhardly do anything against it.”

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.