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ECB seen leaving rates on hold as Trichet bows out

ECB President Jean-Claude Trichet waits for the start of a meeting in Luxembourg
ECB President Jean-Claude Trichet waits for the start of a meeting in Luxembourg

By Paul Carrel

FRANKFURT (Reuters) - The European Central Bank is likely to leave interest rates unchanged when it holds the last policy meeting of Jean-Claude Trichet's presidency on Thursday, but may open the door to a cut under his successor and reintroduce some of its most potent crisis-fighting weapons.

The ECB's Governing Council meets in Berlin against a backdrop of financial market gloom over Greece's debt situation and its impact on the banking sector, with deepening trouble at Franco-Belgian bank Dexia sending investors scurrying for the hills.

Other central banks are looking at loosening monetary policy. The Bank of England is due to consider a fresh round of stimulus on Thursday and Australia's central bank on Tuesday opened the way to a rate cut as early as next month.

However, a jump in euro zone inflation last month to 3.0 percent -- its highest in almost three years and well above the ECB's target of close to but below 2 percent -- will fuel resistance to a cut from the ECB's hawks, who are already upset about the reactivation of the bank's bond-buying plan in August.

"We're not expecting a cut. We think it's a bit premature," said Citigroup economist Guillaume Menuet. "We think it's most likely to happen in November and then to be followed by another move in December."

"The credit numbers are not yet weak enough to suggest that there is a clear knock-on effect from the financial sector worries into the behavior of lenders and inflation is up at 3 percent just before the meet, so I think the hurdles for a cut are still pretty high," he added.

ECB data released last week showed euro zone money supply and loans to the private sector grew at a faster pace in August than in the previous month, weakening the case for a rate cut.

In a Reuters poll of 76 economists, seven expected the ECB to cut rates by 50 basis points at its meeting on October 6, while the majority expect the central bank to keep rates unchanged.

HANDOVER

Trichet will hand over the ECB presidency to Bank of Italy Governor Mario Draghi at the end of this month.

During Trichet's eight-year term, the ECB has kept inflation broadly in line with its target though the euro zone debt debacle following the 2008 financial crisis threatens to tarnish his legacy.

News last month that ECB heavyweight Juergen Stark plans to resign this year -- a move spurred by his opposition to the bond-buying program than many in Germany see as sailing too close to fiscal policy -- highlights the rift at the bank.

Stark is the second German to quit the ECB in protest at the bond program under Trichet's presidency, after Bundesbank chief Axel Weber resigned earlier this year. Weber had been in pole position to succeed Trichet.

Draghi took a hawkish line on monetary policy earlier this year, keen to impress in Germany, where some have seen the fact that he comes from Italy -- a country with a history of high inflation and fiscal ill-discipline -- as a bad portent.

Cutting interest rates at his first meeting in November could exacerbate those German concerns about Draghi, who must also steer policy on the ECB's bond-buy plan, which the bank reactivated to ease pressure on his native Italy.

Trichet could, however, flag a rate cut to smooth the way for Draghi.

"To take the pressure off Draghi, he would pre-announce as much as possible by highlighting the downside risks to the economy and price stability," said Berenberg bank economist Christian Schulz.

LIQUIDITY PROVISION

Economists expect the ECB to unveil plans to pump more liquidity into the market before cutting rates, probably by offering one-year funds to struggling banks, a crisis tactic it last used at the end of 2009.

Media reports say it is also considering resurrecting its covered bond purchase program, a year-long, 60 billion euro program it undertook between 2009 and 2010.

ECB policymakers have recently begun talking about the possibility of reintroducing the 12-month liquidity operation, which would help banks with longer-term fund-raising and so ease interbank tensions.

Banks are increasingly concerned about a possible default of Greece and the potential fallout and have as a result cut back on lending to other banks with heavy exposure to debt-laden euro zone sovereigns, turning to the ECB instead for deposits and lending.

The deepening crisis has already forced the ECB back into emergency mode. It has reintroduced six-month euro funding, a measure it had previously mothballed, and extended limit-free funding in all its lending operations until mid-January.

"This meeting will see a significant widening in liquidity provision, which is what the market needs," said Citigroup's Menuet.

(Additional reporting by Eva Kuehnen, editing by Mike Peacock)

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