September 26, 2011 – By Sakari Suoninen and Martin Santa
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FRANKFURT (Reuters) - European Central Bank officials encouraged hopes of a cut in interest rates to aid economic growth on Monday, although Luxembourg's Yves Mersch warned speculation of a sharp move next month was "wild."
European stock markets surged on the idea that the bank could slash its 1.5 percent main rate by a half-point on October 6, taking back rises it made earlier this year in a bid to dig the European economy out of a deepening crisis.
There are substantial barriers to it doing so, however, not least that the meeting would conclude ECB President Jean-Claude Trichet's term of office with a dramatic U-turn.
"These wild expectations only show that some people have lost the north," Mersch told news agency Market News International in an interview conducted on Saturday, asked about interest rates.
"We have one needle in our compass."
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The last phrase is often used by ECB policymakers to refer to them abiding by the bank's mandate of keeping inflation below 2 percent. Euro zone inflation stood at 2.5 percent in August although it is expected to drop off over the policy horizon the bank uses to guide rate decisions.
In an interview with German daily Boersen-Zeitung published later, Mersch said rate cuts could be considered if the economic situation worsened considerably from current expectations.
"Interest rate cuts are not completely ruled out," he was quoted as saying. "Should there be, compared with current data, a significant worsening of the dynamics of the economy in the euro zone, we do have room to move."
ECB officials signaled on Friday that the bank could be set to restart to offer banks 12-month funds in its liquidity operations to help banks struggling with their fund-raising.
While data on Monday showed the ECB reined in its bond-buying campaign last week, ECB Executive Board member Lorenzo Bini Smaghi said officials had already begun discussing the next steps they would take to quell the crisis.
Mersch said the ECB would do whatever it takes to keep money markets functioning properly, echoing the bank's readiness to reintroduce more of the emergency steps it took to help banks after the 2008 crisis.
Another Governing Council member, Malta's Josef Bonnici, said that it was more important for the ECB to provide sufficient liquidity to banks than argue about interest rates.
"I think more than interest rates ... the provision of liquidity and funds to the banking sector is probably of more significance at this stage," Bonnici told MNI.
Bloomberg also reported, citing unnamed central bank sources, that the ECB is pondering buying mortgage-related covered bonds again, as it did from June 2009 to June 2010. The ECB would not comment on the report.
It is the bank's buying of Spanish and Italian sovereign debt that has divided policymakers and helped prompt the departure of two senior German members. Analysts said the differing tone of public comments also suggested an unusual divide over where to go with interest rates.
"I think this is one of those situations where genuinely the Council will meet and review data that are coming up," Societe General economist James Nixon said.
"I think that more so probably than at any other time in the ECB history, this is a situation where it probably will come down to a harsh vote."
The ECB traditionally favors a consensual mode of decision-making where voting is shunned. But with views on growth and the chance of a recession also varying, differences are big.
While the economic situation has deteriorated, putting downward pressure also on inflation, the ECB's official line at the start of September was that it is less optimistic than before but still expects moderate-paced growth in the euro area.
Executive Board member Juergen Stark on Saturday became the first of the bank's top policymakers to suggest the euro zone could fall back into recession [ID:nF9E7GA01O]) and Ireland central bank Governor Patrick Honohan backed up the gloom in a Reuters interview, pointing to the sharp slide in growth.
Honohan would not comment on interest rates, but said that he saw inflation falling comfortably below the ECB's target.
Germany, euro zone's biggest economy, saw a further decline in business sentiment, the closely-watched Ifo indicator showed on Monday, although the numbers were a touch better than expected.
One major barrier to a rate cut could be the ECB's change of guard. Trichet's eight-year term at the helm of the 17-country bloc's central bank ends next month, and reversing the interest rate increases could be seen as an admission that he made a big mistake when starting to raise rates.
(Reporting by Sakari Suoninen and Martin Santa, additional reporting by Sylvia Westall in Vienna; editing by Patrick Graham)