ECB holds rates, assesses inflation danger zone

he decision to hold the main rate at 0.25% was widely expected

The European Central Bank left interest rates at a record low on Thursday, holding off fresh action for now while it assesses whether it needs to respond to cost-of-living numbers weak enough to raise concerns about deflation.

The decision to hold the main rate at 0.25%, which was widely expected, came despite news earlier this week that euro zone inflation slowed to 0.8% in December - well below the ECB's target of just below 2 percent.

Attention now shifts to ECB President Mario Draghi's 1330 GMT news conference, at which he will explain the reasoning behind this month's decision.

"We expect President Draghi to continue to emphasise that the ECB is ready and able to act if required," said Nomura economist Nick Matthews. "We also expect the ECB to say there are a number of instruments available, though we do not expect them to single out any one at this stage."

ECB watchers will nonetheless be listening for any hints about the central bank's preferred tools for holding down market interest rates, which have begun to creep up as banks repay ECB loans, pulling liquidity stimulus from the system.

With the ECB's main interest rate so low and its toolbox depleting, the threshold for further policy easing has risen, even as the central bank worries about slow price rises.

"We must be very careful that we do not permanently fall below 1% inflation and thus into the danger zone," Draghi told German weekly Der Spiegel last week.

But he added: "We see no need for immediate action."

Economic recovery, while weak, has proceeded as the ECB has expected, giving it time to see whether inflation picks up.

LIQUIDITY

Low inflation is not the central bank's only concern. A lack of lending and receding excess liquidity - the amount of money in the market on top of what banks need for their day-to-day operations - are adding to its dilemma.

Excess liquidity - the money from ECB loans - almost halved overnight to 157 billion euros as banks took up fewer funds from the ECB, which has reduced liquidity further by offsetting its bond purchases.

Early repayments of three-year central bank loans resume next week, meaning even more funds will be siphoned out of the markets, helping push money market rates up more.

Draghi has repeatedly said banks returning money to the ECB is a positive sign and has said interbank markets are working better. But if banks hoard less cash, borrowing costs rise.

The ECB said last month it was watching these developments closely and was "ready to consider all available instruments."

Moreover, lending to companies in the bloc shrank at the fastest pace on record in November and the difference in corporate loan costs around the bloc grew. This suggests the ECB's low rates are still not filtering into all countries.

Last month, Draghi said the ECB would ensure that any new long-term central bank money flowed to the real economy instead of being used by banks to buy government bonds.

However, the ECB is unlikely to announce any steps yet as it monitors the progress in its bank asset-quality review scheduled to start next month.

Draghi has proven to be more nimble on policy than his predecessor Jean-Claude Trichet, who preferred to flag policy moves with key phrases in his statements.

And with the dovish side of the governing council in the ascendancy for now, there is a greater possibility of more abrupt action - if council members can agree how to act.

"I have the impression that while there is in principle a readiness to act, the governing council members don't seem to agree on what exactly should be done and what would really be effective," said Commerzbank economist Michael Schubert.