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ECB readies back door step to loosen policy

By Paul Carrel

The European Central Bank is poised to take action to loosen lending conditions and drag inflation out of a "danger zone" that threatens to stagnate the eurozone's fragile recovery.

Inflation is running at 0.8 percent, far below the ECB's target of just under 2 percent, and banks' early repayment of bumper loans they took from the central bank is draining funds from the financial system - effectively tightening policy.

Reversing this by ending operations to soak up money spent on Greek and other countries' bonds at the height of the euro debt crisis is the prime option for ECB policymakers at Thursday's meeting.

An ECB source predicted there would be unanimous agreement to end so-called sterilization of the bond purchases under the bank's Securities Markets Program (SMP).

The resultant release of around 175 billion euros ($242 billion) would roughly double the amount of excess liquidity in the eurozone financial system, help bring down interbank lending rates and could also lower the euro's exchange rate against the dollar, the source told Reuters.

Germany's influential Bundesbank had agreed to go along with the decision in preference to an interest rate cut that would have meant the ECB having a negative deposit rate for the first time, hitting savers and potentially disrupting the interbank lending market.

The ECB and the Bundesbank declined to comment.

The ECB is running out of room to cut interest rates. Its main refinancing rate is at 0.25 percent and the deposit rate it pays banks for holding their money overnight stands at zero, raising a question over how potent a small rate cut would be.

ECB President Mario Draghi has set out two scenarios that could trigger fresh action: a deterioration in the medium-term inflation outlook and an "unwarranted" tightening of short-term money markets.

Speaking to European lawmakers on Monday, Draghi said inflation in the eurozone is "way below" the ECB's goal.

"We know that the longer it stays at the current level, the higher will be the risk that it will not go back to 2 percent in any reasonable time - in other words, the longer will be the risk that inflation expectations could actually be disanchored, and we don't want that," Draghi said.

The Governing Council will, for the first time, publish staff forecasts stretching into 2016 when it meets, which Draghi described as "a very significant change in our analysis" after the bank's February 6 policy meeting.

Deutsche Bank economist Gilles Moec said the new projections should give the ECB grounds to act.

"You don't need to wait until you have a more-than-even probability of being in a deflation situation to act," he said. "You have to be pre-emptive, and that is where we are right now."

Francesco Papadia, former head of the ECB's financial market operations, said last week he thought the non-sterilization option was "nearly a foregone conclusion" and ECB council members have also suggested action is near.

"I think stopping the sterilization of the SMP purchases would be a rather obvious choice," ECB Governing Council member Ewald Nowotny told Reuters last month.

"I think we are pretty close (to getting unanimity on this) I haven't heard many critical voices but still this is something that has to be reviewed very carefully," he said.

Adding to the pressure on the ECB, International Monetary Fund chief Christine Lagarde said on Monday the Fund saw a risk of an extended period of low inflation in the euro zone and that central bankers must be poised to act.

Despite insisting that the eurozone is not experiencing deflation, Draghi has warned of the risk of inflation getting stuck in a "danger zone" below 1 percent.

A growing minority of economists polled by Reuters last week said the ECB may be forced to print money this year to fight off deflation risks and boost the fragile growth.

Ending the SMP sterilization operations would lack the "wow" factor of such quantitative easing but would show the ECB is being proactive and delivering on its pledge to keep an accommodative policy stance and take fresh action if needed.

"It might be the nice compromise solution," Deutsche's Moec said. "It's not as symbolically charged as the negative deposit rate, it probably doesn't have some of the possible adverse consequences, but would have a similar impact on money market rates."

Taking the deposit rate below zero would see the ECB effectively charge banks to hold their money securely - a move that could see banks respond by lowering their interest rates for savers, of which there are many among Germany's pensioners. [Reuters]

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