European Central Bank could unwind special measures

European Central Bank governors meeting today are expected to leave their main interest rate unchanged at a record low of one per cent while preparing banks for a gradual end to massive supplies of central bank cash, analysts said.

ECB president Jean-Claude Trichet will carefully avoid suggesting that interest rates might start to climb before economic recovery is well underway, however.

The debt crisis in Dubai will also hang over the meeting in light of possible repercussions in eurozone countries such as Greece and Ireland.

But "this week's ECB meeting should bring the first steps towards a gentle backdoor exit" from unorthodox monetary policies aimed at boosting economic activity, ING senior economist Carsten Brzeski forecast.

The 16-nation eurozone has emerged from recession with unemployment at 9.8 per cent, its highest level since December 1998, and Mr Trichet often warns that the economic climate remains uncertain. ECB staff projections for growth are nonetheless expected to be revised upwards from the last estimation of a 4.1 per cent contraction this year and 0.2 per cent expansion in 2010.

Meanwhile, inflation is back in positive territory for the first time in seven months but likely to remain below the ECB target of just under two per cent.

"With a moderate economic recovery and well-anchored inflation expectations, refi rate hikes won't be on the agenda for several months at least," Deutsche Bank analysts said in reference to the ECB's interest rate for refinancing operations.

The ECB has held its main rate at one per cent since May, above the US Federal Reserve's rate of around zero and the Bank of England's main rate of 0.50 per cent.

The ECB has sought to boost bank lending by providing unlimited amounts of central bank cash at that rate, including record one-year loans of €442 billion in June.

"The focus of the next ECB meeting will clearly be on the modification of the liquidity framework," Calyon economist Frederik Ducrozet said.

Mr Trichet is expected to announce that a third 12-month refinancing operation this month will be the last of that length, and the ECB has said it wants to return to the normal situation in which banks bid for a limited amount of funds at variable rates.

"The period of cheap and unlimited excess liquidity is coming to an end," Mr Brzeski said, potentially troubling some banks now believed to depend on ECB funds.

Deutsche Bank analysts said the central bank would aim for "a slow motion exit" that gave "those dependent on the ECB's balance sheet time to prepare and adjust."

Mr Ducrozet said: "The ECB should remain the lender of last resort but no longer the lender of only resort."

The share of ECB funding was now at historic highs for banks in Greece and Ireland, he added.

ECB data shows banks have used cheap central bank funds to earn profits on government bonds this year, meaning the ECB has indirectly underwritten public deficits, something it cannot do directly, the economist noted.

Bank lending to the private sector fell meanwhile by 0.8 per cent in the year through October, following a drop of 0.3 per cent in September, the first such decreases ever.