* Eonia falls to 0.152 from end-year level of 0.446 percent
* ECB seen comfortable with current levels
* Eonia rates might tick higher later this year
LONDON, Jan 3 (Reuters) - A plunge in euro zone money market rates at the start of 2014 following a year-end jump has eased pressure on the European Central Bank to relax its monetary policy still further, but the upward trend may resume in the next few months.
Movements in Eonia, an average of interest rates at which euro zone banks lend to each other overnight, have been extraordinary this week by the standards of the money market, which usually rises and falls in tiny increments.
Eonia surged to a two-year high of 0.446 percent at the end of 2013 as thin liquidity forced banks to overpay for cash, before falling back to 0.152 percent when markets returned to normal.
Eonia traditionally rises sharply on the last trading day of each year when banks need to meet year-end cash targets and liquidity is thin. However, the 2013 peak was almost double the ECB's official refinancing rate of 0.25 percent at which it lends funds to the commercial banks.
This has raised worries that Eonia could trade much higher in 2014 than in past years, even though the ECB has flooded the banking system with cash to bring overnight rates to ultra low levels and help the euro zone recover from its debt crisis.
Higher money market rates effectively tighten the monetary conditions which the ECB loosened only in November when it cut the refinancing (refi) rate to its current record low. A prolonged rise in market rates could endanger the economic recovery, which, based on manufacturing surveys on Thursday and unemployment data on Friday, shows signs of picking up.
Stimulating economic growth is vital for the ECB's goal of avoiding a damaging bout of deflation and lifting inflation from a currently low level back towards its target of just below two percent. Stronger growth would also help countries with lower credit ratings, such as Italy and Spain, to cut their overall debt and put the euro zone crisis to bed.
If Eonia holds around 0.15 percent, this should not create much discomfort for the ECB as it would lie roughly at the mid point between the refi rate and the deposit rate, at which banks park excess cash at the central bank overnight.
This would allow ECB policymakers to keep official rates unchanged when they meet next week, barring any sharp fall in inflation when December data are released on Tuesday, analysts said. "They're not going to jump the gun," said Harvinder Sian, rate strategist at RBS. "But they probably won't be too tolerant of much higher levels."
SCRAMBLING FOR CASH
Eonia's year-end spike should still not be ignored, analysts said. In 2012, a rise to 0.13 percent was followed by a drop to 0.06 percent on Jan. 2, 2013, significantly lower levels than currently.
This is partly the result of banks repaying early some of the more than 1 trillion euros of three-year crisis loans offered by the ECB under its Long Term Refinancing Operations (LTROs) at the height of the debt crisis in late 2011 and early 2012.
These repayments caused the excess cash in the banking system - money beyond what banks need for their day-by-day operations - to shrink from over 800 billion euros in March 2012 to about 275 billion euros at the end of last year.
Such repayments are expected to continue, and the less excess cash in the system, the higher the chances that banks may need to borrow more from other banks, pushing up money market rates.
The banks are now particularly keen to show they are less reliant on ECB loans and can raise more funding in the market. This is because the ECB is conducting an "asset quality review" (AQR) this year, part of a drive to check the health of euro zone lenders before it takes over supervising the most important banks from national bodies in late 2014.
Their wish to have more liquidity on their books for a year-end snapshot to be used in the review may have also contributed to the Eonia surge, some analysts said.
"The AQR, the end-year effect and the repayment of LTRO money led to such a significant spike," Rabobank market economist Emile Cardon said.
Banks scrambling for cash meant that on Dec. 30 the ECB was able to drain only 104.8 billion euros of the 178.5 billion it usually takes out of the system every week.
The draining operations aim to compensate for money the ECB pumped into the system under its Securities Markets Programme (SMP) when it began buying bonds on the debt market at the start of the crisis.
They were introduced to quell concerns, particularly in Germany, that the SMP would be inflationary and lead to the ECB directly financing government budget deficits, which it is forbidden from doing under European law. Draining operations are expected to resume in full in the next few weeks.
"The relatively comfortable excess liquidity cushion might decrease when LTRO repayments pick up again and when the SMP absorption failure is taken away from the excess reserves," Commerzbank rate strategist Benjamin Schroeder said.
Schroeder expects market rates to rise again in 2014, although he does not believe the ECB will react to this as the economic recovery might withstand tighter monetary conditions. However, he says speculation about further ECB easing is likely to pick up later this year.
The ECB has a number of options, Sian at RBS said. It could cease withdrawing SMP money, halve the minimum level of liquid reserves that banks are required to hold - releasing 50 billion euros into the system - or provide more funding in the form of new LTROs with different features.