ECB holds rates, expecting recovery soon

The European Central Bank kept its main interest rate on hold at a record low 0.5 percent on Thursday as it waits to see whether early signs of stabilisation in the euro zone will blossom into an economic recovery.

Economic data improved in May and ECB President Mario Draghi said this week he still sees "a very gradual recovery" starting later this year, taking pressure off the ECB to act again, as it had promised to do if necessary after cutting rates in May.

"This can be seen as a reaction to the slight improvement in the purchasing managers indices (PMIs), which seem to signal that the worst is over in the euro zone," said David Kohl, chief economist for Germany at Julius Baer.

Investors will now shift their focus to the latest ECB staff projections - to be read out during a news conference that starts at 1230 GMT - to gauge how the central bank assesses the currency bloc's economic prospects.

Analysts expect only minor changes to the ECB's outlook from the previous forecasts, released in March.

"They will revise down GDP growth forecasts, while we expect next year's inflation forecast to remain unchanged," Unicredit economist Marco Valli said.

A firm majority of 81 economists polled by Reuters before Thursday's rate decision did not expect the ECB to cut its main refinancing rate or its deposit rate this month or in the near future.

But it will not rule out further policy action, if needed.

"Draghi will try to balance two messages. He will try to sound constructive about the economy and to also leave the door open to further policy easing," JP Morgan economist Greg Fuzesi said in a note to investors.

Purchasing managers index surveys on Wednesday showed euro zone business activity shrank in May, but at a slightly slower pace. Downturns have eased in France, Italy and Spain, and Germany is stabilising, the data showed.

Inflation, which fell to 1.2 percent in April, rose back to 1.4 percent in May, closer to the ECB's target of just below 2 percent, while Eurostat confirmed the bloc's economy contracted by 0.2 percent in the first quarter of the year.

"If data were to disappoint going forward, then a refi rate cut becomes an option," ABN Amro economist Nick Kounis said.

DOOR AJAR

One door the ECB will not close is the option of taking its deposit rate into negative territory from zero now - although few analysts believe it has immediate plans to do so.

At last month's post-rate decision news conference, Draghi said the central bank will look at negative deposit rates "with an open mind and we stand ready to act if needed".

But that might be ammunition the ECB wants to keep unused - at least unless the economy enters a downward spiral.

"It's not never-ever, but probably a lot would have to happen for it to happen," ABN Amro's Kounis said.

Other possible options could include moves to boost lending to small and medium-sized firms (SMEs), the economy's backbone, although plans to do so are unlikely to have been finalised.

Varying borrowing costs in different parts of the common currency area have developed into a major headache for the ECB, with firms and consumers in the debt-ridden south having to pay much higher interest rates than their counterparts in the north.

After months of hinting at action, the ECB has lately sought to temper expectations, warning against expecting a bazooka.

ECB Vice-President Vitor Constancio said last week that one should not "overblow" options the ECB has to repair the market for asset-backed securities, which could help access to funding when bank lending channels are blocked.

European Council President Herman Van Rompuy said on Friday he expected a joint proposal with the European Investment Bank to improve SME financing this month, although the ECB seems content to be a junior partner in any such scheme.