ECB to hold rates, Draghi faces Monte Paschi grilling

The European Central Bank is unlikely to contemplate an interest rate cut at Thursday's policy meeting despite the euro's sharp rise, but its chief almost certainly faces a grilling afterwards over an Italian banking scandal.

The euro's strength will need to show significant harm to the economy before the Governing Council reverses course, and there is next-to-no chance of that happening at its monthly meeting.

Far more likely is that the appreciation will delay discussion of an exit from the ECB's crisis policy. And a given is that President Mario Draghi will face questioning from reporters over the scandal at Monte dei Paschi .

At Thursday's news conference Draghi can expect to be asked how much he knew about the derivatives scandal at Monte Paschi, and what he did about it when he headed Italy's central bank from 2006 to 2011.

ING economist Carsten Brzeski expected Draghi to remain tight lipped. However, he said the scandal would shine a light on the difficulties the ECB faces in building up a euro zone-wide banking supervisory body that is credible but separate from its main business of setting interest rates. "It only stresses that the supervisory role is a hell of a job," said Brzeski.

Italy's third largest bank has been at the center of a financial and political storm since it revealed it faced losses of about 720 million euros ($986 million) from a series of derivatives and structured finance trades.

Draghi should have an easier ride on monetary policy,

None of the 75 economists surveyed in a Reuters poll last week forecast a cut in rates from their record low of 0.75 percent on Thursday. The poll suggested the ECB would not change its rates until at least July 2014.

Deutsche Bank economist Gilles Moec, who has just completed a report on the foreign exchange 'pain threshold' for euro zone economies, found that France and Italy are already suffering from the euro's appreciation but that Germany is comfortable.

The currency has risen about 3 percent against the dollar since the ECB's last monetary policy meeting on January 10, when Draghi unwound expectations the ECB would cut rates soon.

"In terms of the pain threshold for the euro zone as a whole, we're right on it," Moec said. "So at the euro zone aggregate level, there is no massive pressure that would force the ECB into paying immediate attention to this."

"You would have to see a clear impact on some data" from the euro's rise before changing course on rates, said Moec, pointing to export orders and purchasing managers' indices. "You need a smoking gun, and the smoking gun is not there."

A batch of indicators cited by Draghi at his January 10 news conference show the economic distortions of the euro zone debt crisis are starting to correct themselves, with the data flow positive over the last month.

"IRRATIONAL MOVEMENTS"

Some officials have nonetheless begun to complain about the euro's rise this year to a 14-month peak against the dollar and a 30-month high versus the yen.

French President Francois Hollande said on Tuesday the euro zone must develop an exchange rate policy to protect the currency from "irrational movements". Last week, French Industry Minister Arnaud Montebourg said "the euro is too high".

The appreciation reflects the Federal Reserve's promise to keep buying bonds until U.S. unemployment falls much farther and the Bank of Japan's plan for a much looser monetary policy. By contrast, the market-driven unwinding of some of the ECB's crisis funding measures has fed investors' perceptions that it is in a state of de facto tightening, supporting the euro.

"For the ECB, at this stage, at least it's a good reason to tell people like (Bundesbank chief Jens) Weidmann 'you see it's not the right time for us to start talking about an exit strategy because the currency appreciation is already doing this to a large extent'," Moec said.

Banks have repaid early a chunk of 3-year crisis loans they took from the ECB, reducing the amount of excess cash in the financial system and pushing up bank-to-bank lending rates.

The Eonia overnight lending rate has risen to 0.079 percent from 0.071 since the ECB's January 25 announcement on the first early repayment.

Banks repaid 137 billion euros at the first opportunity to do so, and will hand back another 3.5 billion on Wednesday.

The ECB's balance sheet is likely to have shrunk to around 2.8 trillion euros as a result, the lowest level since February 2012. This is in stark contrast to the expansionary policies being pursued in the United States and Japan.

But with the ECB mandated to deliver price stability, the Governing Council is bound to focus on keeping inflation in check. Euro zone inflation eased to 2 percent in January, near the ECB target of close to, but below 2 percent.

"Markets have and continue to overestimate the ECB's willingness to cut rates that are already at rock bottom levels, including if the euro goes up another few big figures or Eonia creeps higher, barring any significant drop of economic forecasts into negative territory," said Sassan Ghahramani, CEO of U.S.-based SGH Macro Advisors, which advises hedge funds.

(editing by David Stamp)