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FRANKFURT (Reuters) - The European Central Bank cut its growth and inflation forecasts on Thursday, warning of possible further trouble from China and paving the way for an expansion of its already massive 1 trillion-euro plus asset-buying program.
The ECB, which left interest rates unchanged in a widely expected decision, said growth would suffer from fading momentum in emerging markets, particularly China, and falling oil prices could drag the 19-member euro zone back into deflation in coming months.
The new projections are a stark admission that Europe's recovery, described by the bank as disappointing, is hardly gaining momentum. Consequently, the ECB may have to roll out new measures, just six months after it began quantitative easing, considered a policy "bazooka" when it was introduced in January.
For the first time, ECB President Mario Draghi said explicitly the bond-buying program may run beyond September 2016 and the bank may adjust its size and composition. As it stands, the ECB is buying 60 billion euros ($66.68 billion) per month asset buys, mostly government bonds.
"There aren’t special limits to the possibilities that the ECB has in gearing up monetary policy," Draghi told a news conference. "The risks to the euro area growth outlook remain on the downside, reflecting in particular the heightened uncertainties related to the external environment."
The euro fell 1 percent against the dollar on Draghi's comments, European stocks rallied and bond yields fell as investors started to price in new policy steps from the bank.
"The words chosen by the ECB suggest that it would not hesitate to raise the size of its asset purchases and prolong them beyond September 2016 if the outlook for growth and inflation weakens further," Holger Schmieding, an economist at Berenberg said.
"As far as such conditional statements go, the ECB was rather clear: It would not take much further turbulence to trigger an ECB response. We can count this as a clear verbal intervention.”
In one small change to the quantitative easing scheme, a possible precursor for further moves, the bank increased the share of any sovereign bond issue it could buy to 33 percent from 25 percent, provided that did not give it a blocking minority among bondholders.
"September 2016 is still a long way off, and the market would probably not be much impressed by the announcement of a mere continuation of the purchases beyond this date," Commerzbank economist Joerg Kraemer said.
"We think the ECB is more likely to announce a higher monthly purchase volume, fuelling expectations that it will extend its bond purchases well beyond September 2016," Kraemer added.
The ECB expects euro zone headline inflation, now running at 0.2 percent, to average just 0.1 percent this year, down from previous expectations of 0.3 percent.
Even for 2017 the bank lowered its forecasts to 1.7 percent from 1.8 percent. That suggests hitting its inflation target of just under 2 percent may be difficult even years from now.
Adding to uncertainty, Draghi said the forecasts were made in the first half of August. The worst of China's market volatility and the drop in oil prices came later, so the figures may still be too optimistic.
However, the domestic outlook is relatively healthy. Lending is increasing, unemployment falling and the latest composite purchasing managers' index rose unexpectedly.
Meanwhile, the external outlook changed for the worse. Growth in China, the world's biggest economy, is expected to reach a two-decade low, hurt by soft demand, over-capacity and falling investment.
Its economy has been further buffeted by plunging shares and a surprise devaluation of the yuan, a combination of factors that is rattling global markets and could strain relations with China's major trading partners.
Draghi said China's faltering growth would also weaken other emerging markets, with ramifications for the rest of the world.
"It is never an easy task to engineer an orderly deleveraging process, especially as the country also faces other structural problems," RBS said. "A less well-controlled credit crunch in China can have contagion effects into other countries."
The ECB now sees GDP in the euro zone growing 1.4 percent this year, below its previous 1.5 percent projection. The forecast for 2017 was cut to 1.8 percent from 2.0 percent. Draghi said the cuts were caused by weaker external demand.
A majority of analysts polled by Reuters before Thursday's meeting expect the ECB to extend or increase its asset purchases. Three quarters said the bank has simply run out of tools and that adjusting QE was its only viable option left.
Writing by Balazs Koranyi and Paul Taylor; Editing by Jeremy Gaunt, Larry King