European Central Bank to Hold Fire For Now as Crisis Rages

The European Central Bank is expected to hold its nerve and leave interest rates at 1.0 percent when it meets on Wednesday, as it presses political leaders to come up with a solution to the euro zone's raging debt crisis and avoid a breakup of the currency.

Spain is struggling to avoid becoming the fourth euro zone member to ask for a bailout while Greece's June 17 election could yet drive it out of the bloc, potentially unravelling the whole project, including the ECB.

Economists view the decision whether to cut rates or not as one of closest calls in years with awful data in recent weeks, which included unemployment hitting a record high, leaving it facing a far harsher euro zone recession than imagined.

The turmoil and deepening market sell-off that has accompanied a new wave of the debt crisis in recent weeks adds to headwinds for the economy. Yet although there is a visible split on the ECB's policymaking council, most economists think it is unlikely to take action.

In a Reuters poll 62 out of 73 analysts said they expected the bank to hold rates at a record low of 1 percent next week.

"Every time the ECB intervenes it takes the pressure off the political leaders and political leaders end up doing nothing. And this time they are not playing that game any more," said Societe Generale economist James Nixon.

"This time we are going to go right to the edge of the abyss."

The recent deterioration is likely to be reflected in a downward revision of the ECB's staff projections for the economy, while most analysts it is a fore-gone conclusion that it will also extend its provision of emergency support to banks.

This week President Mario Draghi explicitly placed the ball in the court of governments, saying the bank cannot fill the policy vacuum currently hurting the euro and calling on leaders to foster closer financial and political cooperation.

Nixon believes the ECB has become fed up with the negative side-effects its actions earlier in the crisis have had. By leaving rates on hold it also leaves itself more room to respond if the crisis does not abate over the next two weeks.

"The ECB wants to keep its powder dry with respect to the outcome of the Greek election," said Nixon.

OUT OF TOUCH

The respite the ECB had bought markets at the beginning of the year by injecting more than 1 trillion euros into the euro zone's banking system with twin 3-year loan operations, is fading fast with borrowing costs for troubled countries once again soaring.

Euro zone unemployment stood at a record 11 percent in April, business confidence has slumped and surveys of manufacturing have hit three-year lows, adding to conviction that the bloc's economy will drop back into recession in the second quarter of the year.

"The case for a rate cut is overwhelming," said Ken Wattret, chief euro zone market economist at BNP Paribas. "The ECB's scenario of a gradual return to growth looks increasingly out of touch with reality."

But with the ECB having flooded money markets with cash, its main refinancing rate already at 1 percent and the rate the ECB pays banks for overnight deposits at 0.25 percent, others question how effective another cut would be.

"If anything the economy's deterioration makes you think that there are increasing downside risks to price stability."

The question is whether the ECB will respond immediately with a rate cut. "I think they should," said Wattret, who has pencilled in a 25-basis point rate cut for Wednesday. "But I'm wondering whether the ECB will play for time."

A broad majority in the Reuters poll expects a downward revision of the ECB's staff projections for growth for this year and next from the last report in March.

Inflation projections are expected to remain largely unchanged from March.

"I don't see an inflation problem in the euro area at all," Wattret said.

BUYING TIME

Spain would prefer the ECB buy it some time by reactivating its bond-buying programme. But Draghi is likely to remain unflinching as he looks to keep the heat on, also knowing that the 212 billion euros spent so far have had little success.

Spain needs to find a way to come up with the necessary funds to recapitalise its ailing banking sector and the longer the country waits, the higher its refinancing costs get, making it more likely that it will have to ask for international help.

The cost of insuring against a Spanish default hit 600 basis points for the first time on Thursday and the country's 10-year government bond yields neared 7 percent - a level that is seen by some analysts as unsustainable.

While interventions in the bond market seem off limits, some economists see a slight chance for another longer term refinancing operation to soothe banks' funding strains.

Anna Grimaldi, economist at Intesa Sanpaolo, said an operation with an even longer maturity than the 3-year loans, for example four or five years, could not be ruled out.

"An operation on longer maturities would probably calm concern about liquidity of banks in peripheral countries on a longer time frame, this would give some extra time to banks," Grimaldi said.

With just a couple of weeks before the ECB's current promise to provide banks with limit-free funding expires, the ECB is set to decide for how long to extend the arrangement to avoid any new funding fears developing. (Reporting By Eva Kuehnen; editing by Patrick Graham)