Frail recovery and low inflation will limit ECB's options on rates

The European Central Bank holds its first meeting of 2010 this week amid expectations its main interest rate will stay unchanged at least until the end of the year, while the US recovery eclipses that of the eurozone and inflation undershoots its target.

Since its last interest rate decision, in early December, financial markets have pushed out even further the expected date of the first ECB increase from the current record low of 1 per cent, with a quarter percentage point rise now seen only in December.

Some economists forecast rates will be on hold even longer. However, with worries growing about the distortions it may be creating in financial markets, the ECB will continue to withdraw gradually the emergency help for eurozone banks offered since the collapse of Lehman Brothers. Short-term market interest rates, which have fallen lower than the official policy rate, could rise as a result later this year.

Although continental Europe's worst recession since the 1930s ended formally in mid-2009 and the 11-year-old ECB has a reputation for hawkishness, recent data have highlighted the fragility of recovery. ECB forecasts last month showed inflation would undershoot its target of an annual rate "below but close" to 2 per cent this year and in 2011.

Julian Callow, European economist at Barclays Capital, also pointed to fears about the impact of the crisis over Greece's public finances. "There is really no reason for the ECB to change tack at this [Thursday's] meeting," he said.

Eurozone retail sales data last week showed conditions still deteriorating on high streets, and private sector borrowing continues to contract. "The ECB will probably not consider rate hikes until a turnround in lending to the corporate sector is visible," argued Michael Schubert at Commerzbank in Frankfurt.

Eurozone unemployment hit double-digits in November for the first time since the launch of the single currency, according to data last week. US companies shed jobs rapidly at the onset of the crisis, while government subsidies allowed eurozone industry to hoard labour temporarily. But such trends could now be thrown into reverse.

"We expect the labour market to turn around pretty soon in the US and to start generating jobs again. In Europe that would be premature - there are more jobs to be shed," said Elga Bartsch at Morgan Stanley.

However, the ECB will distinguish between measures aimed at controlling inflation and its help for banks.

In December Jean-Claude Trichet, president, an-nounced a scaling-back of its liquidity provision this year and hinted that from April it could start to move away from the matching in full banks' demands for funds. Other policy instruments could also be used to withdraw liquidity from the banking sector.

An objective is to wean eurozone banks off their dependence on ECB liquidity injections. But economists suspect the ECB could also use such steps to start a monetary policy tightening "by stealth".