China becomes the key challenge to ECB’s objectives

Even with developments broadly in line with expectations, the recovery remains disappointing, as noted in the latest ECB Monetary Policy Accounts, with inflation "unusually low". Adding the latest developments in China will only make the Governing Council more concerned over the prospects of achieving inflation close to 2% in the medium term. 

Even if events in China do not drastically alter the outlook for core inflation in the euro area through weaker foreign demand, the ECB may still need to act if rising rates in the US (due to the Fed) spill over to Europe.

In this context, China may also play a role for higher US rates, in case China engages in further interventions to defend the CNY, thereby running down some of its reserves of foreign assets. Another possibility of an unwarranted tightening of the ECB's policy stance is if the euro again strengthens in a global equity market sell-off as carry-trades unwind (or if the Fed delays rate hikes), although such scenario is likely also to lead to lower interest rates. In any case, the ECB will need to stand ready to act.