ECB expected to cut, may take more to sustain markets

FRANKFURT (Reuters) - The European Central Bank is expected to cut interest rates to a record low on Thursday but may need to do more to satisfy financial markets already starting to wonder about the solidity of last week's summit measures to tackle the euro zone crisis.

Steady inflation and a dire batch of economic performance indicators, including signs of weakness in euro zone powerhouse Germany, give the ECB cover to back up the EU summit deal with a quarter-point cut in its benchmark rate to 0.75 percent.

The ECB has never cut its main refinancing rate below 1 percent but policymakers say there is nothing to stop them doing so and they may want to bolster euro zone leaders, even if they never admit to such 'quid pro quo' deals.

At the summit, ECB President Mario Draghi strolled into the middle of the media zone to declare his satisfaction with the agreement to speed up cross-border banking supervision and to allow the euro zone rescue fund to recapitalize banks directly thereafter.

"I think Draghi saying that he is happy with the summit results is a strong sign that the ECB is ready to do something," said Christian Schulz at Berenberg Bank, forecasting a quarter-point cut.

But Schulz, a former ECB economist, added: "We think if it's just a rate cut, that would be a disappointment for markets because a rate cut would not do very much at all for the peripheral economies ... that's why something else is needed."

Markets have rallied since the EU meeting, which also empowered the ECB to lead the supervision of European banks and opened the way for the rescue fund to intervene on debt markets to support troubled members, though Finland and the Netherlands have questioned this bond-buying provision.

Even with political backing, there are questions over the rescue fund's capacity to lower borrowing costs. It has a maximum 500 billion euros capacity with 100 billion already earmarked for Spanish banks, a sum which could quickly dwindle.

Those limitations put a spotlight back on the ECB's readiness to take 'non-standard' measures - such as reactivating its own bond-buy program or offering banks fresh liquidity.

The ECB calmed investors earlier this year by unleashing over 1 trillion euros into markets with twin 3-year funding operations, or LTROs. Andrew Bosomworth at bond fund Pimco expected the bank to hold off any further such measures.

"I don't think the ECB will do more super-long LTROs or impose spread caps as a quid pro quo for what EU leaders agreed at the summit," said Bosomworth, a senior portfolio manager.

"If they are going to go down that route, then hopefully it would be in response to fending off deflation, not that we hope for deflation, rather than as a gift to the Italian government for passing a mediocre labor market reform," he said.

DEPOSIT RATE

A Reuters poll of economists showed the majority expected the ECB to cut its main rate to 0.75 percent.

The ECB board member in charge of economics, Peter Praet, said last Wednesday there was nothing to stop the bank cutting rates further, firming expectations for a cut.

In addition to the main refinancing rate, the ECB has two other interest rates: the marginal lending rate that banks use for emergency overnight borrowing which now stands at 1.75 percent, and its deposit rate - now at 0.25 percent.

A cut in the deposit rate, which acts as a floor for the money market, to as low as zero could encourage banks to lend to each other rather than simply parking funds of up to 800 billion euros back at the ECB every night.

But even if the ECB cuts the deposit rate, banks may still be unwilling to lend to peers in euro zone periphery countries if they are not convinced of their creditworthiness.

Money market traders are evenly split on whether the ECB will cut the deposit rate, a Reuters poll showed.

Policymakers have deep reservations about taking other measures, such as reactivating the bank's bond-buy plan - a tool many investors would like it to use to cap the bond yields of countries embroiled in the euro zone crisis.

The ECB spent some 210 billion euros in the last two years to buy Greek, Irish, Portuguese, Spanish and Italian bonds without achieving any lasting improvement.

With the ECB's bond program such a hot potato, Draghi is likely to be asked at Thursday's post-meeting news conference about another crisis response option: allowing the ESM fund to have access to the central bank's ultra-cheap loans.

That would boost the ESM's firepower and allow it to intervene with real impact on bond markets, where Spain's benchmark yields are still well above 6 percent. So far, both Germany and the ECB are opposed.

(Editing by Mike Peacock)

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