By Paul Carrel
FRANKFURT, Oct 2 (Reuters) - European Central Bank policymakers meeting on Wednesday are likely to hold off policy action for now but keep open the options of an interest rate cut or a bumper cash injection should the euro zone outlook sour.
The 23-member Governing Council meets in Paris against a backdrop of inflation slowing to a 3-1/2-year low, a limp euro zone recovery, political turmoil in Italy, and volatile market interest rates swayed by U.S. Federal Reserve policy.
ECB President Mario Draghi last week raised the possibility of action if market rates push too high for comfort, saying the banking system could again be primed with long-term loans if necessary.
But market rates - which moved higher over the summer at the prospect of the Federal Reserve unwinding its stimulus - have eased since the U.S. central bank held off starting the process for now, relieving pressure on the ECB to take immediate action.
Draghi nonetheless underlined the ECB's readiness to act, saying last week that, if needed, it could use another LTRO - ultra-long loans it issued in late 2011 and early 2012 to pump over 1.0 trillion euros ($1.35 trillion) into the system.
'An LTRO is generally seen as not necessary at this point but is useful to keep on the table both as a preventive cap on (market) rates rising ... and as a backstop for the broader banking system,' said Sassan Ghahramani, ceo of U.S.-based SGH Macro Advisors, which advises hedge funds.
Offering banks a 3-year LTRO at a fixed rate that could be reset if the ECB cuts its benchmark interest rate would 'effectively put the ECB balance sheet firmly behind the promise to keep rates 'low or lower',' said Ghahramani.
Seeking to guide down market rates, the ECB said in July it would keep its rates at current or lower levels for an 'extended period' - its first use of forward guidance. The ploy struggled to gain traction until the Fed delayed unwinding its stimulus.
A majority of economists in a Reuters poll expect the ECB to keep its key rate at 0.5 percent until at least April of 2015. But they expect it will serve up another course of LTROs to banks, possibly by the end of this year.
ECB Executive Board member Benoit Coeure said last week the bank was monitoring money market rates and had a number of tools it could use if needed.
'It's not an urgent decision,' he added.
The euro zone economy is broadly sticking to the ECB's scenario for a slow recovery. Inflation slowed to 1.1 percent in September - its lowest since February 2010 and a level that allows the ECB to maintain its loose monetary policy.
However, manufacturing growth in Italy and Spain eased off in September, surveys showed on Tuesday, highlighting the fragile state of the recovery in the euro zone periphery. Battered Greece's contraction deepened.
On Monday, the ECB and the European Commission said Spain's slack economy and a fall-off in lending posed a risk to its banks.
Italy's political troubles - keeping a fragile coalition government from having to call new elections - are also in the background, but the ECB does not usually get involved publicly in such matters.
'I don't see the Council budging an inch in response to the latest Italian crisis,' said RBS economist Richard Barwell. 'Like parents trying to bring out the best in their children, Council members are trying hard to be consistent and predictable and impervious to melodrama in their dealings with politicians.'
A new LTRO could aim to raise excess liquidity - the amount of money beyond what the banking system needs to function - and ease banks' funding situation before the ECB's asset quality review (AQR) next year, a precursor to its new supervisory role.
But the fall in market rates has relieved some of the pressure to act, and the ECB risks disappointing markets if banks, which have been repaying early some of the twin LTROS from 2011 and 2012, show little interest in additional loans.
The forward rate which shows where one-year Eonia rates are seen in a year's time, has fallen to levels last seen in July when the ECB launched its forward guidance.
'I think the market is getting ahead of itself on the timing and likelihood of LTROs,' said RBS's Barwell. 'They are an option on the table but there are some potential drawbacks.'
'Having promised not to let supervisory concerns influence the monetary policy debate, the decision to extend very long-term emergency funding to weak banks on the eve of the AQR may raise awkward questions,' he added.
($1 = 0.7387 euros)
(Writing by Paul Carrel) Keywords: ECB/RATES
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