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UPDATE 2-Eyes on Spain as ECB meets, bazooka at the ready

Thursday, 4 Oct 2012 | 5:35 AM ET

* ECB rate decision due at 1145 GMT, news conference 1230

* ECB expected to hold rates at 0.75 pct

* Draghi to be questioned on Spanish bailout negotiation

(Update throughout) By Eva Kuehnen

BRDO PRI KRANJU, Slovenia, Oct 4 (Reuters) - European Central Bank President Mario Draghi will keep his bond-buying bazooka on display when the bank meets on Thursday, but Spain's reluctance to request aid from EU partners means he is unlikely to pull the trigger soon.

A month after Draghi unveiled the bond-purchase plan that was hailed by many as a saviour for the single currency bloc, investors are still waiting for Madrid to bite the bullet on a rescue.

Before it does, the ECB cannot act, and markets are likely to remain jittery. Spanish two-year note yields have climbed more than half a percentage point in the weeks since Draghi's plan was unveiled - a reminder that action not words are needed to resolve euro zone's three-year old crisis.

"Given that the ECB's actions are hostage to the political debate, in particular the EU/Spain dialogue on Spain's request for (European Union) aid, some news that Mr. Draghi himself is encouraged by developments will go a very long way to provide support to the market," economist Lena Komileva at G+ Economics said.

The central bank's governing council is expected to hold interest rates steady on Thursday after its meeting outside the Slovenian capital of Ljubljana, to allow time for new details to emerge on the health of the euro zone economy and inflation.

Since announcing his plan to buy the short-term debt of struggling euro zone countries to reduce their borrowing costs, Draghi has stressed repeatedly that it is up to governments to take action.

But he will nonetheless be quizzed on his assessment of the current negotiations on Spain, which has announced new budget measures in recent weeks to try to regain the confidence of markets.

Beset by anti-austerity protests and threats of secession by the wealthy northwestern region of Catalonia, Spanish Prime Minister Mariano Rajoy has resisted a formal aid request, in part because Germany opposes it, sources told Reuters this week.

He is also worried about the perception that Spain's policies are being dictated from abroad, although analysts said the ECB was unlikely to attach stricter conditions to any bond-buying than those set by the EU and the IMF.

"The ECB will not be setting additional conditionality, you cannot reasonably expect it to do that," said Unicredit economist Marco Valli, who believes Spain will apply for aid after local elections later this month.

RATE HINTS

The ECB's main refinancing rate is already at a record low of 0.75 percent and analysts expect the bank to save any rate cut until the new bond programme has started.

Economic indicators do not make a clear case for lower interest rates either. While they signal that the euro zone returned to recession in the third quarter, inflation remains high.

A majority of 73 economists polled by Reuters said they expected no change on Thursday in Slovenia, one of two annual meetings away from its Frankfurt base.

"We do not expect the Governing Council to cut interest rates at this meeting. We believe that only cutting the main refinancing rate would be little more than a gesture," Royal Bank of Scotland economist Richard Barwell said in a note.

ECB Executive Board member Benoit Coeure said last week that economic and inflation data did not justify an October cut - a view echoed by Austria's central bank governor Ewald Nowotny.

Wednesday's purchasing managers indexes (PMIs) showed companies faced dwindling orders and faster layoffs. But consumer prices rose at an annual rate of 2.7 percent in September, the 22nd month that inflation has been above the ECB's target of just below 2 percent, limiting its room to act.

The ECB has also said its interest rates are not filtering through to households and companies, especially in troubled southern Europe where lending rates are much higher.

It hopes the new bond programme will reduce borrowing costs.

A small majority in the Reuters poll expect the ECB to cut the refinancing rate to 0.5 percent by the year end, however, so economists will be eager to see if Draghi drops any hints.

That would also raise questions about a deposit rate cut. It stands at zero so that would take it into negative territory.

The ECB would then effectively charge banks to hold their money overnight but some policymakers, including Nowotny, say this would create problems.

"We have already seen quite a lot of decisions outside the box, yet another measure outside the box before we have seen any implementation of what is already on the table might create more confusion than benefit for the market," said Komileva of G+ Economics.

(Editing by Noah Barkin/Jeremy Gaunt)

((eva.kuehnen@thomsonreuters.com)(49 69 75651244)(Reuters Messaging: eva.kuehnen.thomsonreuters.com@reuters.net))

Keywords: ECB/RATES