(REUTERS) - The European Central Bank is expected to cut rates and unveil a new package of bank aid on Thursday, with markets also watching for any hint it will intensify its bond-buying support for the bloc's struggling members, setting the stage for a critical euro zone summit.
The ECB meeting, which has already started, comes a day before a supposedly make-or-break EU summit which will aim to agree on key rule changes to anchor coercive budget discipline for the 17 countries that share the euro.
The ECB is hoping to persuade the bloc's governments to give Brussels more say on their spending and accept automatic sanctions if they step out of line - issues it sees as crucial to fixing the region's problems long-term - by dangling the prospect of scaling up its purchases of troubled states' debt.
A senior euro zone source said before the start of the summit that a proposal to give the bloc's permanent bailout, the European Stability Mechanism, a banking license - which could allow it to access ECB funds, boosting its firepower - was off the table.
That leaves the ECB as the only European institution with the means to sway markets and increases pressure on the bank to ramp up its purchases of the bonds of euro zone countries hit by the crisis - a ploy which can ease their borrowing costs.
A Reuters survey of 73 analysts showed a 60-percent chance the ECB will cut rates by 25 basis points for the second month running, back to the record low of 1.0 percent it reached during the financial crisis in 2009.
With the euro zone in such turmoil it may also signal that going below 1.0 percent with rates is no longer an ECB taboo.
New ECB President Mario Draghi, who has had a pro-active first month in charge of the bank, reinforced expectations for a rate cut last week when he warned the euro zone's economy was deteriorating and stressed the bank would fight deflation as aggressively as it does inflation.
The case for a cut will also be supported by revised ECB in-house economic forecasts which are expected to show the euro zone teetering on the brink of recession and set for a turgid year ahead.
And while inflation remained at 3 percent for the third month in a row in November, euro zone unemployment figures inched up to 10.3 percent in October.
We expect a 25 basis point cut in rates, there is a chance that that won't happen, but given the fact a recession may already be upon us, a rate cut is certainly warranted, said Standard Chartered economist Sarah Hewin.
We are also expecting a lowering of growth forecasts to something much more gloomy and that along with the stresses hanging over the euro zone will set the tone for the meeting.
Perhaps the most intense focus will be on what the ECB signals it is prepared to do regarding bond purchases.
France and Italy but also the United States and Russia have all put intense pressure on the ECB to use its potentially unlimited firepower to calm a crisis that is casting a dark cloud over the global economy.
Earlier this week S&P also warned that its threat of a mass downgrade of euro zone member ratings would be tough to avoid if larger ECB bond buying was not part of Friday's summit deal.
The bank remains uncomfortable about the purchases but Draghi hinted last week it could take stronger action if European leaders agree on tighter budget controls, comments ECB watchers took as code for stepping up its bond purchases.
However, with the EU summit just round the corner Draghi is expected to remain deliberately vague at the 1330 GMT press conference.
Goldman Sachs, whose European economists are now headed by Huw Pill, a top ECB official until earlier this year, doubts the ECB will go all the way and set a ceiling above which they would not allow Italian and other strained euro members' borrowing costs to go.
We expect the ECB to move progressively towards more proactive purchases on a larger scale. But any such actions will fall short of attempts to 'cap spreads', Pill said in a note.
We do not think the ECB to act more proactively soon, based on the commitments and statements of intent that emerge on Friday.
BANK SUPPORT MEASURES
Sources have also told Reuters the bank is likely to start offering banks funding for two or even three years for the first time ever, to try to prevent the euro zone crisis precipitating a credit crunch that chokes the bloc's economy.
One of the decisions it will have to make at its meeting is whether it charges a premium for the funding or has the cost track the bank's headline rate as in other operations.
It is also expected to make it easier for banks to get its funding by further expanding the menu of assets they can swap for ECB loans, something Draghi has also hinted at by saying the bank is aware of the funding difficulties some banks are facing.
What really matters is what the ECB does tomorrow afternoon, and in that especially what they do with the long-term refinancing operations and on the collateral rules, Societe Generale economist Michala Marcussen said.
The ECB has already reinstated some of its most potent crisis-fighting tools in recent months in a bid to calm escalating tensions in bank-to-bank lending markets. Last week it, the Fed and a clutch of other top central banks slashed the cost of the dollar loans they offer banks.
Euro zone officials are also now in the process of discussing using money from national central banks to boost International Monetary Fund resources, with one senior euro zone official telling Reuters that would be limited to 150 billion euros, at the low end of a range of estimates that have been circulating.
The ECB's view on such a move will be another area of focus at the meeting and add to the complex web of potential support strands the central bank could offer to dovetail with political measures to solve the crisis.
The problem is that everyone is looking for the big bazooka, but the reality is that what we're seeing is the lining up of muskets. But if you imagine an army of muskets, at the end of the day that can prove very efficient, said Societe Generale's Marcussen.