The European Central Bank is likely to cut interest rates on Thursday and offer ultra-long liquidity operations to support banks, while leaving the door open to further measures to fight Europe's debt crisis if governments agree fiscal reforms.
A Reuters survey of 73 analysts showed a 60-percent chance the ECB will cut rates by 25 basis points to a record low of 1.0 percent -- a floor it previously reached during the financial crisis in 2009. It cut rates by a similar amount in November.
New ECB President Mario Draghi reinforced expectations for a rate cut last week when he said the bank had a responsibility to ensure inflation did not undershoot its target of just below 2 percent, not just to stop it exceeding it.
Markets have taken it to heart. Three-month Euribor futures -- one of the main gauges of market expectations -- point to rates being be cut this month and then even further.
The case for a cut is supported by the euro zone economy teetering on the brink of recession. With the ECB increasingly concerned about falling consumer prices, further cuts may be in the offing even if the ECB has never cut rates below 1 percent before -- not even after the collapse of Lehman.
This week's ECB meeting, meanwhile, comes at a key time for the currency bloc -- just before a supposedly make-or-break EU summit on Friday that aims to agree on a treaty change to anchor coercive budget discipline for the 17-nation currency area.
The timing of this policy meeting is a little bit tricky as it comes shortly before the EU summit. That's why I expect the ECB not to show all its cards, but to wait and see what the summit comes up with, said DZ Bank economist Thomas Meissner.
Draghi hinted in his comments to the European Parliament last week that the ECB could take stronger action to fight the crisis if European leaders agree on tighter budget controls.
The comments, however, should not be seen as part of a grand bargain between the monetary and fiscal authorities, but rather as a recognition of the absence of any alternative, David Mackie at JP Morgan argues.
If the ECB does not step up ex ante, it will be dragged in ex post by financial instability, Mackie said.
Draghi made his comments a day after the world's major central banks took emergency joint action to provide cheaper dollar funding for starved European banks.
This was the latest in a slew of actions aimed at propping up European banks, which are struggling with the fallout from the debt crisis, such as higher capital requirements and rising tension in the interbank money market.
Banks are increasingly turning to the ECB and the recent jump in overnight deposits at the ECB has highlighted the freeze in interbank lending markets.
Sources have told Reuters that the ECB is looking at extending the term of loans it offers banks to 2 or even 3 years to try to prevent the euro zone crisis precipitating a credit crunch that chokes the bloc's economy.
The ECB first introduced extra-long 12-month liquidity tenders in June 2009. In October, it renewed offers to lend banks one-year funding in two operations this year -- a 12-month longer-term refinancing operation (LTRO) in October and a 13-month operation in December.
At these operations, banks receive all the funds they ask for. But there has only been lukewarm interest, suggesting that more ECB cash may not be the answer to a creeping credit freeze.
The ECB could also further ease eligibility criteria on the collateral against which it gives loans to commercial banks.
Economists expect the ECB to keep mum on its government bond purchase programme on Thursday -- ahead of the EU summit and as long it remains unclear what governments are prepared to do.
It sharply slowed its bond purchases last week as expectations mount it could be more aggressive in the coming months if euro zone leaders show a willingness to surrender some national powers to save the euro.
Borrowing costs for Italy and Spain have risen to unsustainable levels as the debt crisis spread, putting pressure on politicians to find a viable solution should the euro zone's third and fourth largest economies be cut off from the markets.
Euro zone officials said the bloc was discussing the option of financing emergency help for Italy or Spain by using money from national central banks to boost International Monetary Fund resources -- but only as a last resort.
Euro zone officials have offered various guesses on the possible size of loans to the IMF, ranging from significantly less than 100 billion euros to several hundred billion euros, but a decision has not been taken yet.
However, such a solution also comes with risks.
If the IMF then, we think the technical advice and monitoring role should definitely be there, a flexible credit line might help too, but a full stand-by arrangement can easily backfire, said Andrew Bosomworth, head of Pimco's portfolio management in Germany.
He added that it was important that Spain and Italy retained market access throughout the process and that this was also a crisis about the governance structure of the euro zone, which Europe could fix itself without resorting to the IMF.
Those concerned about moral hazard should not just be fixated on 1923. The deflation of 1932 was also very damaging. That is what Europe needs to prevent now, Bosomworth said.
Draghi's recent comments indicated the ECB is concerned about the possibility of consumer prices falling and new inflation and growth forecasts from the ECB's in-house economists are likely to be revised down from September.
Euro zone inflation remained at 3 percent for the third month in a row in November, while the jobless rate in 17-nation currency bloc inched up to 10.3 percent in October from 10.2 percent in September.
(Reporting By Eva Kuehnen)