By Anirban Nag
LONDON (Reuters) - The European Central Bank has flagged the prospect of asset purchases if the euro keeps rising, yet few investors and analysts are convinced that even Japanese-style money printing would decisively weaken the euro.
A decisive ECB move to break what many had thought to be a taboo on quantitative easing - at least within Germany, the euro zone's largest economy - could cap the euro. But analysts and fund managers think any QE programme would be modest, making a major reversal of the exchange rate unlikely.
Underlining the strength of the taboo that would have to be broken, the ECB stands alone among the world's three major central banks in letting its balance sheet contract.
By taking money out of the economy, that process supports the euro - especially when the Federal Reserve is still buying $55 billion (32.68 billion pounds) worth of assets a month while the Bank of Japan pledged a year ago to inject $1.4 trillion within two years.
Analysts reckon the ECB would have to inject up to 2 trillion euros into the economy to shift the euro lower - and they see no clear signs that the ECB can agree to do so.
Earlier this month, ECB President Mario Draghi opened the door to money printing as a means of warding off any threat of persistent price deflation and preventing excessive euro strength from snuffing out tentative economic recovery.
Yet subsequent signals show how wary the ECB still is of QE. A source on Monday said Draghi had told German lawmakers outright money-printing was still a way off.
The ECB's balance sheet is shrinking because euro zone banks are repaying cheaper loans handed out during the debt crisis. This is pushing up short-term money market rates and increasing the euro's allure for investors seeking higher yields, especially those from the United States and Japan.
The euro is just below 2-1/2 year highs against a trade-weighted basket of currencies and hovering above $1.38 versus the dollar, up 0.6 percent on the year.
In Japan, expectations of QE and the subsequent "shock and awe" announcement weakened the yen sharply.
But "if you are looking for a BoJ-type impact, you could be disappointed," said Kenneth Dickson, investment director at Standard Life Investments, Edinburgh.
"The ECB has always said that the situation in the euro zone is different from Japan. So while QE will push the euro lower, we do not expect the 10-15 percent decline we saw in the yen."
Annual euro zone inflation is stuck at 0.5 percent, way below the ECB target of just under 2 percent in the medium term, and euro strength is making imports cheaper.
Lower inflationary expectations can lead to lower wage agreements and households deferring purchases, sucking the euro zone into a downward price spiral similar to the Japanese experience of periodic deflation since the 1990s.
NOT JAPAN, YET
So far, ECB policymakers have been at pains to say that the euro zone is not Japan. Nevertheless, media reports suggest the ECB is doing studies based on 1 trillion euros (820.05 million pounds) of asset purchases over a year to boost inflation.
While the number looks equivalent to the BoJ plan in dollar terms, it is slightly lower as a share of the balance sheet. The ECB's balance sheet stands at around 2.2 trillion euros, so an expansion by a trillion euros will not lead to a doubling of the balance sheet as is the case with the BoJ. The BoJ's balance sheet is expected to nearly double by end-2014.
Both fall shy of the Fed, whose balance sheet has grown to over $4 trillion from $900 billion before the financial crisis.
Hans Redeker, head of global FX strategy at Morgan Stanley, said it would take a 1.5-2 trillion euro QE campaign to induce sustained weakness in the euro.
Citi economist Guillaume Menuet, who expects QE in September, doubted that a trillion euros of asset purchases, would be enough to change the euro zone's economic outlook.
It is not hard to see why. The BoJ's programme has yet to lift inflation to its targeted 2 percent rate. Expectations are growing the BoJ will have to do more this year to boost prices.
COMPLACENT MARKET?
Unlike the yen which lost nearly 15 percent since Japanese Prime Minister Shinzo Abe came to power in late 2012 and the BoJ announced its asset buying programme in April 2013, or even the dollar which weakened after second round of QE was flagged in August 2010, the euro has shown little signs of weakening.
There has been some demand for downside strikes in the euro with investors betting that the currency will drop to $1.37 after the ECB meeting next week, but beyond that there is hardly any pricing that QE is on the cards.
"Investors want ECB to walk the talk," said Howard Jones, partner at RMG Wealth Management, London. "Right now, there are doubts that there is unanimity about QE within the ECB."
Besides, the ECB needs to navigate national variations to find suitable QE purchases, and work quickly if it wants to develop a market where it can buy asset-backed securities.
All this means that even if the ECB does launch a QE programme it will probably not be enough to turn the tide against the euro.
"I don't think the ECB will do a BoJ-style stimulus. Rather any QE will be very gradual," added RMG's Jones.
(Graphics by Vincent Flasseur; Editing by Ruth Pitchford)