ECB keeps rates at 1 percent, to set exit in slow-motion

The European Central Bank kept rates at a record low of 1 percent as expected on Thursday, leaving markets firmly focused on how it plans to handle the delicate process of phasing out its financial crisis support.

With markets still some way from normality, all 80 economists in the latest Reuters poll had predicted the rate decision

. Currency and bond markets were little moved by the decision.

The focus will now be on what ECB President Jean-Claude Trichet says at his 1330 GMT news conference on scaling back the emergency lending the ECB has used to get the euro zone's financial system through the credit crisis and limit the recession.

A new set of ECB staff forecasts on the economy are also due, which for the first time will stretch as far as 2011 and should show a marked increase in economic optimism.

Trichet has dropped a number of hints since the last policy meeting that this month's handout of one-year loans will be the last, while he and other policymakers have stressed the ECB's support will not be needed to the same degree going forward.

This (rates kept on hold) is really what was expected, they are still far from considering raising interest rates, said Barclays Capital economist Thorsten Polleit.

The most important aspect is the issue of the one-year refinancing operation. I think they will confirm that this is the last one, but I think there is still some heckling whether it will be at 1 percent or indexed.

It has the option of either leaving the cost of borrowing at its main interest rate or charging banks a little bit more.

The latter would be taken by traders as a signal it intends to raise rates at some point next year, but another option that now appears under discussion would be to have the one-year rate track any future benchmark rate hikes.

Nomura economist Laurent Bilke thinks the ECB will also make other adjustments. We look for some limited restrictions to 6-month maturity operations, such as reducing their frequency.

The expected moves would bring an end to more than a year of intensive ECB policy easing and herald a change of direction.

But policymakers will probably to want to avoid pushing a rapid exit plan at this stage with countries like Spain still in the grip of recession, unemployment set to rise further and an already-strong euro threatening to sap the fledgling recovery.

Some central banks such as Australia's and Norway's have already begun to raise rates. But the U.S. Federal Reserve has stuck to its commitment to ultra-low interest rates while taking some small steps to wind down its emergency support.

At the far end of the scale, the Bank of Japan this week offered to pump more funds at banks to lower longer-term money market rates.

Markets are also hoping to hear how long the ECB plans to keep uncapped lending in place. The new expiry date that the ECB puts on support measures will also be seen as a litmus test of the ECB's intensions.

We think a reasonable horizon for (when measures will be extended to) would be April 2010, said Bilke.

It is sufficient for the new scheme to be effective while not tying up the ECB for too long. A longer horizon toward mid-year is also possible, but any shorter than April would sound hawkish to us.

IMPROVED FORECASTS

New ECB staff forecasts on the economy are also due.

The answer (to how fast the ECB unwinds support) lies in how well the economy does after New Year, and therefore the key issue tomorrow is their new staff forecasts, said Goldman Sachs economist Erik Nielsen.

Markets are expecting a hefty upgrade to 2010 growth given the euro zone's emergence from recession in the third quarter. Inflation numbers should also be nudged up after a stronger than expected return to positive territory last month.

HSBC economist Janet Henry expects 2010 growth at a mid point of 0.8 to 0.9 percent compared with the 0.2 percent seen in the ECB's last forecasts.

She added 2011 numbers should show inflation -- the ECB's main focus -- still well under its target of close to but just below 2 percent, noting that would keep down chances of a rate hike before September.

Trichet's terminology will, as always, be scoured. With the economy still in a delicate phase, he is expected to say the bank's record low 1 percent interest rate remains appropriate.

He is also expected to employ a verbal shove or two during the post-rate decision news conference to try to push down the euro down having seen it jump back above $1.50.

He and other European officials failed last week to convince China to let its currency appreciate, but were he to sharpen his tone on the euro's rise, it could rattle the common currency.

(Reporting by Marc Jones; Editing by Ruth Pitchford)