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ECB to keep rates on hold, remind market of readiness to act

Sakari Suoninen
Wednesday, 8 Jan 2014 | 7:01 PM ET

* ECB rate decision at 1245 GMT

* News conference beginning at 1330 GMT

* No new measures expected this month

* Draghi seen emphasising easing bias

FRANKFURT, Jan 9 (Reuters) - The European Central Bank is likely to keep interest rates on hold on Thursday while reminding the market that it will ease policy if inflation stays too low or money market conditions tighten too much.

ECB President Mario Draghi will reassure investors that the bank will not tolerate inflation holding persistently in the "danger zone" below 1 percent.

ECB watchers will also be listening out for any hints about the central bank's preferred tools for keeping market interest rate rises at bay.

Annual euro zone inflation dipped to 0.8 percent in December from 0.9 percent in November, data showed this week, well below the ECB's target of just below 2 percent.

Economists nonetheless expect the bank to keep its powder dry this week after cutting its main rate to a record low of 0.25 percent in November.

"I don't think they see a need to act now," Deutsche Bank economist Mark Wall said, adding the ECB would keep its options open.

"It will be ... a watchful ECB, still dovish with its tone, forward guidance maintained, so a formal easing bias very much in place."

In a Reuters poll, all but one of 55 economists said they expected no change, and a large majority expect rates to stay at their current level until at least mid-2015.

With its main rate so low and its toolbox nearly depleted, the threshold for further easing has risen, even as the central bank worries about slow price rises.

"We must be very careful that we do not permanently fall below 1 percent inflation and thus into the danger zone," Draghi told German weekly Der Spiegel last week.

But he added: "We see no need for immediate action."

Economic recovery, while weak, has proceeded as the ECB has expected, giving it time to see if inflation picks up.

Still, Draghi could choose to emphasise his deflation-busting credentials this month.

"We may hear more about the fact that the ECB is ready to use any tool to fight deflation without taboos," Credit Agricole economist Frederik Ducrozet said.

New euro zone member Latvia will be represented at the meeting for the first time, with its central bank governor, Ilmars Rimsevics, getting an equal vote to that of his peers from much larger economies around the now 18-member bloc.

LIQUIDITY

Low inflation is not the central bank's only concern. A lack of lending and receding excess liquidity - the amount of money in the market on top of what banks need for their day-to-day operations - are adding to its dilemma.

Excess liquidity may almost halve to 150 billion euros ($204 billion) this week as banks take up less funds from the ECB, which has reduced liquidity further by offsetting its bond purchases.

Early repayments of three-year central bank loans resume next week, meaning even more funds will be siphoned out of the markets, helping push money market rates up more.

Draghi has repeatedly said banks returning money to the ECB is a positive sign and has said interbank markets are working better. But if banks hoard less cash, borrowing costs rise.

The ECB said last month it was watching these developments closely and was "ready to consider all available instruments."

Moreover, lending to companies in the euro zone shrank at the fastest pace on record in November, while the difference in corporate loan costs around the bloc grew, suggesting the ECB's low rates are still not filtering through in all countries.

Last month, Draghi said the ECB would ensure that any new long-term central bank money flowed to the real economy instead of being used for government bonds.

However, the ECB is unlikely to announce any steps yet as it monitors the progress in its bank asset-quality review scheduled to start next month.

Draghi has proven to be more nimble on policy than his predecessor Jean-Claude Trichet, who preferred to flag policy moves with key phrases in his statements.

And with the dovish side of the governing council in the ascendancy for now, there is a greater possibility of more abrupt action.

"Never underestimate the ECB ... They have been capable of surprising markets with the design of policy time and time again," Deutsche's Wall said. ($1 = 0.7349 euros)

(Editing by Hugh Lawson)