ECB seen on hold, but wary of slipping into 'danger zone'

By Paul Carrel

FRANKFURT (Reuters) - A surprise drop in euro zone inflation will concern European Central Bank policymakers but they will likely do no more on Thursday than warn of their readiness to act in future.

The policymaking Governing Council meets after data showed annual euro zone inflation dipped to 0.8 percent in December from 0.9 in November. The ECB targets inflation of just below 2 percent.

Core inflation, which strips out volatile costs like food and energy, hit a record low of 0.7 percent.

The readout will heighten concerns at the ECB about entrenched price weakness taking hold, though strong company activity towards the of last year will give them some comfort.

"Obviously they are worried, but it's not significantly lower than it was a month earlier," Anders Svendsen at Nordea said. "I don't think it's enough to prompt a new rate cut but I do think it's enough to keep them dovish and ready to act."

The ECB cut its main interest rate to a record low 0.25 percent in November after inflation slid to 0.7 percent. No change is expected this week, though ECB President Mario Draghi has stressed the bank still has room to act.

"We are not seeing any deflation at present," he told German magazine Der Spiegel late last month. "But we must take care that we don't have inflation stuck permanently below one percent and thereby slip into the danger zone.

The ECB's readiness to contemplate using new policy tools means it is diverging from the U.S. Federal Reserve, which is poised to wind down its stimulus this year.

Peter Praet, the ECB's chief economist, raised the possibility in November of the ECB embarking on asset buys - or quantitative easing (QE) - just as the Fed prepares to scale down its QE programme.

It would probably require a period of inflation at zero and lower - and the threat of a Japan-style lost decade that would pose - for a majority on the ECB council to support printing money.

The ECB has also vowed to keep interest rates "at present or lower levels" for an extended period. Other policy options include a new liquidity operation, which many economists expect the ECB to offer banks in the coming months.

COURT RULING

ECB policymakers, gathering for the first time after welcoming Latvia to the euro zone on January 1, face a divergent inflation and growth picture across the 18-country bloc.

In Greece, annual inflation is running at minus 2.9 percent and the economy is in recession. In Germany, inflation is 1.2 percent and the private sector grew for the eighth month running in December.

Bundesbank chief Jens Weidmann, an arch-hawk on the ECB's Governing Council, said last month that although low interest rates were justified, weak inflation did not give a licence for "arbitrary monetary easing".

The ECB holds Thursday's meeting without Joerg Asmussen, another German who has given up his Executive Board seat to return to government in Berlin.

Asmussen has not yet been replaced, though Germany has proposed Bundesbank Vice President Sabine Lautenschlaeger to take his post. [ID:nL6N0JW2KW] Little is known about her views on monetary policy, though she will likely take a hawkish line.

The dynamics of the Governing Council will take on added significance ahead of a ruling expected soon by Germany's Constitutional Court on the ECB's OMT bond-buying programme - it's as yet unused mechanism to protect the euro zone.

The court is considering whether the ECB's backstop of buying "unlimited" amounts of bonds from stricken euro zone states, announced in 2012 at the height of the bloc's debt crisis, is really a vehicle for funding member states through the back door. That could violate German law.

Any pressure to deploy further unorthodox, or non-standard, policy measures could risk upsetting the Bundesbank and change the mood music in Germany ahead of the ruling.

"OMT remains the most important tool the ECB has committed to, so the German Constitutional Court ruling is important," said Christian Schulz at Berenberg bank.

"If they (the ECB Governing Council) don't have to, they will probably try to avoid provoking an angry reaction in the German media," he said. "If they can, I think they will hold fire and the data at the moment allows them to do that."

(Editing by Mike Peacock)