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ECB to hold course, keep eye on gathering storm clouds

Ralph Orlowski | Getty Images

The European Central Bank is set to stick to its policy course on Wednesday while keeping a wary eye on stumbling blocks to the euro zone's nascent recovery.

Fresh political turmoil in Italy after former premier Silvio Berlusconi told his ministers to quit the coalition government could cause jitters beyond Italian shores, particularly if early elections are required.

ECB chief Mario Draghi last week raised the possibility of action if market interest rates push too high for comfort, saying the banking system could again be primed with long-term loans if necessary.

But Wednesday's Governing Council meeting in Paris - one of two meetings theECB holds outside of Frankfurt each year - is unlikely to see it delve back into its policy toolbox, not least because the U.S. Federal Reserve has eased the pressure to act.

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Former ECB boss: Europe must not be complacent

Confidence is returning to the 9.5 trillion euro economy, although growth is anemic, justifying the ECB's pledge to keep interest rates low or lower for the foreseeable future.

The ECB made that pledge, also known as forward guidance, in July to fend off pressure on money market rates in light of a looming slowdown of the Fed's bond purchase program and dwindling amounts of excess liquidity.

The Fed has since put off that plan but excess liquidity - the level of cash beyond what banks need to cover their day-to-day operations - is falling, which has sparked speculation the ECB could pump more money into the system.

(Read more: Why the Fed won't taper until 2014: Bond guru)

"The biggest focus for markets will be around assessing the probability and potential timing of any additional long-term refinancing operation (LTRO)," said Nomura economist Nick Matthews.

"But while Draghi will repeat that the ECB has several policy options that can be used if needed, I would expect him to fall short of signalling another LTRO is imminent," he said.

The ECB is concerned that higher short-term money market rates that banks use when lending to each other could hurt the euro zone's recovery and push inflation - now at just 1.1 percent - further away from the ECB's target of close to 2 percent.

(Read more: ECB's Draghisays euro zone recovery 'fragile)

None of the economists polled by Reuters last week expected an interest rate cut from 0.5 percent when the ECB meets on Wednesday, a day earlier than usual because of a holiday in Germany on Thursday.

Political events in Italy are also for now not seen affecting monetary policy.

Does Europe need more LTRO?

"Unless Italy is formerly applying for a precautionary credit line, what's happening in Italy now does not have any implication for ECB policy," said Anna Maria Grimaldi, European economist at Intesa Sanpaolo.

(Read more: Italy faces new elections and economic turmoil, analysts warn)

Tools on the shelf

Expectations for another round of ultra-cheap long-term funding grew last week after Draghi said the ECB was paying close attention to the lower level of additional funds in the banking system and that it was ready to act if needed.

Other ECB policymakers were more equivocal but the fact is that excess liquidity has fallen to 208 billion euros from more than 800 billion early last year, approaching a level expected to push market rates closer to the main refinancing rate.

In a Reuters poll, 42 of 56 economists said they expected a another LTRO, possibly by the end of the year. The ECB funneled over a trillion euros to banks with twin three-year liquidity operations in late 2011 and early 2012.

(Read more: More cheap loans for Europe's banks?)

"We think there is a pretty high likelihood that we see another LTRO by the end of the year," said Goldman Sachs chief European economist Huw Pill, who previously worked at the ECB.

"The beauty of the LTRO is that there are many reasons that speak in favour of it, it can build a coalition on the Council. Other possible measures would be more difficult to agree on."

Another LTRO could aim to raise excess liquidity, ease banks' funding situation ahead of the ECB's asset quality review next year, increase the ECB's support for smaller companies by accepting collateral that favours these companies and it could strengthen the ECB's forward guidance by tying it to low rates.

Other policy tools, such as cutting the main refinancing rate to 0.25 percent, reducing the reserve ratio banks have to hold at the ECB to zero thereby freeing up another 100 billion euros, or no longer taking the money the ECB pumped into the market via its first bond purchase program out on a weekly basis would each have a more limited impact.

"We are not sure the ECB has entirely decided what to aim for yet and, importantly, money market rates have declined significantly since the last meeting," JP Morgan economist Greg Fuzesi said.

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.