ECB faces grilling on euro debt storm

The European Central Bank faces a grilling over the euro zone's debt crisis on Thursday after a torrid month in which it has abandoned resistance to buying government debt and flung its exit strategy into reverse.

With the ongoing debt troubles continuing to rattle the euro zone, all 79 economists recently polled by Reuters expect the ECB to keep interest rates at their record low of 1.0 percent again.

The ECB's news conference is set to be dominated by the sudden shift to bond buying. It abandoned a long-held resistance to the tactic on May 10, just 4 days after ECB President Jean-Claude Trichet said buying bonds was not discussed at the ECB's last meeting.

The ECB had bought and settled 40.5 billion euros worth of bonds as of Friday. But it has still given no hint of how much it is prepared to spend or how long it could buy bonds for.

"This meeting will be the first occasion for the ECB to properly communicate on its bond purchase programme, and it comes at a particularly critical moment" said Nomura economist Laurent Bilke.

"The market is clearly questioning the determination of the Eurosystem now, as country spreads are back to their widest in some cases - Spain, most noticeably."

Another key focus of the meeting will be new 2010 and 2011 growth and inflation projections from ECB and euro zone central bank staff.

They are expected to make brighter reading than in March, partly due to better global demand but also to the region's debt crisis, which has wiped 17 percent off the euro's value in the last six months on a trade-weighted basis.

"I expect the recent decline in the euro/dollar exchange rate to be reflected in the inflation projections" said Credit Agricole's Frederik Ducrozet.

"They will show something like 1.5 percent for 2010 and 1.7 percent in 2011 compared with 1.2 and 1.5 percent 3 months ago."

Growth forecasts for this year should also be revised up to around 1 percent, he added. A strong second quarter and the euro's drop should outweigh the negative impact of the debt woes.

As a rule of thumb, a 5 percent drop in the euro tends to boost growth in the 16-country bloc by around 0.4 percentage points, according to economists.

Trichet is expected to stress, albeit with caution, that economic recovery remains on track.

He may sound a little more hawkish on inflation, say economists, although forecasts of 1.5 - 1.7 percent would still leave the ECB, which aims to keep inflation just under 2 percent, some breathing room from rate hikes.

"There'll be no change in (interest rate) policies," said Goldman Sachs' chief European economist, Erik Nielsen.

"Trichet will mention the words "exit strategy" several times, but I very much doubt that he'll give anything concrete away at this stage - why should he" he added.

MONEY MARKETS

The debt troubles of Greece, Portugal and other financially strained euro zone members have also reignited fears about the health of the region's commercial banks.

It has hit money market trading, forcing the ECB to reverse its exit strategy and reintroduce dollar lending, inject another round of 6-month cash and extend unlimited 3-month lending.

Markets are also bracing themselves for July 1 when banks have to repay a record 442 billion euros borrowed last year.

The ECB has the option to further extend limitless lending. Another 6-month lending operation would have little impact on the ECB thinking, but analysts appear doubtful.

"There is ample excess liquidity in the banking system at the moment, more than at any time since the ECB put in place its exceptional arsenal" said Bilke.

"We expect no further liquidity announcement this week, and particularly no additional longer term refinancing operation with full allotment."

RIFT AT TOP

The ECB inadvertently published an internal test message on Wednesday saying it would issue three-month debt certificates offering up to a 1 percent interest rate.

An official told Reuters the alert should be disregarded, however the slip up has ignited speculation that the bank plans something similar to offset the inflationary threat of its bond buys.

Analysts say Trichet will also have important repair work to do during Thursday's 1230 GMT news conference.

The controversial step to start buying government debt has opened a deep rift on the ECB's top table, pitting Trichet against ECB and Bundesbank heavyweight Axel Weber.

Weber has openly criticised the move, arguing it creates "serious stability risks." Economists warn the split is undermining the ECB's efforts to stabilise markets and could suck it further into the murky waters of European politics.

"Trichet will be asked to comment on divergent views, if not conflicts within the Governing Council" said Credit Agricole's Ducrozet.

"He will likely refuse to react to individual comments while describing himself as the captain of the team. Not sure he will manage to convince the market on this point."