The European Central Bank is expected to cut its main interest rate to a new record low of 1 percent on Thursday and step up efforts to boost the flow of funds from banks to euro-zone companies and households.
Since the ECB's last meeting, data have confirmed that the euro-zone economy probably kept contracting at the start of 2009 while inflation is set to fall sharply, backing the case for more central bank action.
Economists see only a slim chance the ECB will follow other major central banks and announce a debt-buying program on April 2 -- the same day that Group of 20 leaders meet in London to discuss a joint response to the financial crisis.
Although comments from policymakers like Vice-President Lucas Papademos suggest the ECB is warming to the idea of bond purchases, for now it is tipped to extend the maximum loan term for its liquidity operations, potentially lending banks funds for 12 months or more compared to the current six months.
In a further twist, analysts also expect the ECB to cut its lowest policy rate, the overnight deposit rate, by less than the main refi rate to avoid driving money market rates down too low.
Economists polled by Reuters expect the ECB to cut the overnight rate, which is acting as a floor for markets under the ECB's policy of injecting unlimited amounts of liquidity, by only 25 basis points to 0.25 percent, stopping short of zero.
Eight out of 10 economists polled expected the main refi rate to be cut by 50 basis points to 1 percent, with only a small number predicting a smaller, 25-point move or a freeze at the current 1.5 percent.
There is a risk that they could split the move to 1 percent, they could do 25 basis points this month and 25 basis points in May, said Stephen Gallo, head of market analysis at Schneider Foreign Exchange.
But I think the risks are skewed to 50 basis points at the April meeting.
Cutting the main refi rate to 1 percent and the deposit rate to just 0.25 percent would narrow the ECB's rate corridor, an approach it tried late last year and then abandoned after banks took the opportunity to park excess funds at the central bank rather than lend them on.
But analysts said this was unlikely to happen again, especially if the ECB also extends the maturity of tenders as many expect following blunt hints from policymakers including Papademos and Axel Weber that this is on the cards.
I would not expect that to result in an increase in deposits at the ECB, said Ralf Preusser, fixed income strategist at Deutsche Bank in London.
The market is less risk-averse now ... longer-term repos would give the market even more confidence that the liquidity will not be taken away from them quickly.
LONGER LOAN TERMS
Financial markets are pricing in a 25 basis point rate cut, but this reflects more their expectation of how much the deposit rate will be lowered, rather than the size of the refi rate reduction they are anticipating, given overnight rates have been trading below the refi rate for some time.
Figures derived from Eonia rates flag that the market is anticipating a narrowing in the gap between the deposit rate and the benchmark interest rate to 75 basis points from the current 100 basis points.
The market is expecting a 50 basis point cut in the refi rate but pricing actually shows a 27 basis point reduction because of shifts in the liquidity and the potential narrowing of the rate corridor, said Nomura rate strategist Charles Diebel.
ECB President Jean-Claude Trichet's comments after the meeting will also be closely scrutinized for signs that the ECB may match moves by the U.S. Federal Reserve, the Bank of England and others and start buying assets directly.
Papademos said last week that buying private debt securities was a potential option, as well as longer maturities for liquidity operations, although analysts generally do not expect the ECB to overcome a range of technical and political hurdles on this in time to reach a decision on Thursday.
However, longer maturities for liquidity operations would help boost the flow of credit to banks, which account for the bulk of financing to euro-zone companies and consumers.
The main problem that the ECB has to deal with right now is the commercial banking sector, so supplying as much liquidity as possible ... definitely the risk is that they will expand those operations, said Schneider's Gallo.
Academic and economic adviser to the German government, Peter Bofinger, said longer maturities would have the side-effect of ensuring refinancing for all euro-zone countries.
If you can give the ECB Irish or Greek bonds as collateral and receive long-term liquidity in exchange, for a year for example, then there will also be demand for these bonds, he said.
Analysts said purchasing corporate paper would be supportive for high-yielding peripheral euro zone government debt, such as Greek and Italian paper, but could see other debt underperform.
While it might be seen as positive for credit, it could be unfortunate for yields in general and you may see some curve steepening because they're not buying government bonds, rather taking a smaller approach in a different market, said Calyon rate strategist David Keeble.