By Eva Taylor
FRANKFURT (Reuters) - The European Central Bank is poised to impose negative interest rates on its overnight depositors, seeking to cajole banks into lending instead and to prevent the euro zone falling into Japan-like deflation.
At its meeting on Thursday, ECB policymakers may also launch a loan programme for banks with strings attached to make sure the money actually gets out into the euro zone economy.
It will be the first of the "Big Four" central banks - ECB, Bank of England, Bank of Japan and U.S. Federal Reserve - to go the negative interest rate route, essentially charging banks to deposit with it.
Even though the risks are limited of the euro zone entering a spiral of falling prices, slowing growth and consumption, the ECB is increasingly concerned that persistently low inflation and weak bank lending could derail the recovery.
The economy grew just 0.2 percent in the first quarter, and euro zone annual inflation unexpectedly slowed to 0.5 percent in May, official data showed this week, piling additional pressure on the central bank to step in.
"Consensus for action is high so there is a ... risk the ECB under-delivers relative to the market's lofty expectations," said Andrew Bosomworth, a senior portfolio manager at bond fund Pimco in Munich.
Since ECB President Mario Draghi last month signalled the Governing Council's readiness to act in June, policymakers have come out in force to discuss the ECB's toolbox, feeding expectations that a broader stimulus package is in the making.
This is likely to consist of a cut in interest rates, which would push the deposit rate for the first time into negative territory and the offer of longer-term loans linked to further lending. Large-scale asset purchases remain a distant prospect.
Cutting the deposit rate below zero would see the ECB charge banks for parking their excess money at the central bank - a step it hopes will prompt them to lend out the money instead.
Economists in a Reuters poll expected the ECB to cut its main refinancing rate to 0.10 percent from 0.25 percent and the deposit rate to -0.10 percent from zero, on top of launching a refinancing operation aimed at funding firms.
They expect bank lending to rise as a result of such measures, but foresee only a marginal impact on the euro.
The euro has fallen about 4 U.S.-cents against the dollar since the ECB's May meeting, hitting $1.3586 last Thursday.
QE-BAZOOKA ON THE SHELF
Before taking any decision, the Governing Council will look at the June update of its quarterly staff projections. In March, they showed it would take 2-1/2 years for inflation to get near the ECB's target of below but close to 2 percent.
A deteriorating outlook is seen triggering action.
Euro zone inflation has been stuck in what Draghi has called "the danger zone" below 1 percent since October, mainly because of weaker commodity and food prices, but also because of wage and other adjustments in euro zone crisis countries.
The stronger euro exchange rate exacerbates these dynamics.
At the same time, record low interest rates are still not feeding through evenly to companies across the currency bloc. Companies in Portugal, for example, are paying on average 5.4 percent on loans compared with 2.2 percent in Finland or France.
This particularly affects smaller companies, which rely strongly on bank funding and make up the bulk of the economy.
A programme that offers banks longer-term funds at a cheap rate if they can prove that they increase lending, combined with even lower interest rates, would aim to address these issues.
An extension of the ECB's unlimited provision of liquidity in its main refinancing operations beyond July 2015 would also give banks more assurance about future funding conditions.
A move to deploy so-called quantitative easing (QE) - money-printing to buy assets - remains some way off.
"We expect the big QE-bazooka to remain in the closet," said ING economist Carsten Brzeski.
(Editing by Jeremy Gaunt)