The European Central Bank is watching exchange rate and credit dynamics carefully and stands ready to act should it see signs of a negative price spiral taking hold, ECB president Mario Draghi said yesterday.

Draghi said credit constraints were putting a brake on the recovery in stressed countries and the effects of an appreciating euro exchange rate would hold down overall eurozone inflation, though the ECB still expects a gradual return of inflation to its target of below, but close to 2 per cent.

There is a risk that disinflationary expectations take hold

“Our responsibility is nonetheless to be alert to the risks to this scenario that might emerge and prepared for action if they do,” Draghi said in introductory remarks for the new ECB annual Sintra central banker conference.

“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.“There is a risk that disinflationary expectations take hold.”

Draghi detailed possible responses to different scenarios, saying 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”.

A destabilising of inflation expectations “would be the context for a broad-based asset purchase programme”.

If credit supply constrains interfered with the ECB’s transmission of monetary policy, that would require more targeted measures.

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 per cent from 0.5 the previous month, but also showed that the eurozone economy grew less than expected at the start of the year.