By Eva Taylor and Jonathan Gould
FRANKFURT (Reuters) - Weaker oil prices could lead prices to contract over the next months in the euro zone's largest economy, but that would not justify broad-based
sovereign bond purchases by the European Central Bank, the chief of Germany's Bundesbank said.
The ECB is watching carefully how a recent drop in oil prices will affect euro zone inflation, now at 0.3 percent and far below its target of just below 2 percent, and standing ready to do more to keep the region from slipping into deflation.
Oil fell to just above $59 a barrel for the first time since May 2009 on Tuesday.
Having largely exhausted its policy toolkit with the key interest rate at a record lows of 0.05 percent, broad-based purchases of sovereign bonds - also known as quantitative easing (QE) - are seen as the ECB's last resort to revive the economy.
But some ECB policymakers have reservations. Bundesbank head Jens Weidmann is the most vocal opponent of such a step in the 24-member Governing Council, concerned the central bank could end up bankrolling troubled euro zone governments and lose sight of its mandate to keep prices stable.
"Against the background of the rather moderate and uncertain impact as well as the risks and side effects and the not clearly given necessity at the current point in time, I am currently sceptical of a broad-based QE programme," Weidmann told members of a Frankfurt-based journalists' club late on Monday.
The Bundesbank earlier this month lowered its inflation and growth projections for the coming years, but the adjustments did not reflect the most recent drop in oil prices, which meant the inflation forecasts could still be missed, Weidmann said.
"The inflation rate could even fall below zero in the next months," Weidmann said, stressing that an inflation rate that stayed below zero for several months would not necessarily mean deflation - a self-sustaining downward spiral of contracting prices and low or no economic growth and falling wages.
"This risk remains small," he said. Even though long-term inflation expectations had fallen over the course of the year, "I would not speak of an un-anchoring despite the decline".
The ECB has stepped up preparations for possible further stimulus. Weidmann said models had shown that QE may be able to lift euro zone inflation, "but marvellous things are not to be expected".
"Substantial volumes would be needed to achieve a moderate and moreover uncertain impact," Weidmann said. QE could lead to a mutualisation of risks among tax payers of euro zone member states, "unless the purchases would be limited to countries with the highest credit-worthiness or each
central bank bought bonds of its own government at their own risk".
(Editing by Larry King)