FRANKFURT (Reuters) - The European Central Bank still has room to cut interest rates if needed, although this may pose a financial stability risk, Christine Lagarde, the bank's likely future president said on Thursday.
Lagarde added that a broader review of how monetary policy is conducted was warranted.
With growth slowing and inflation persistently undershooting the ECB's target, the bank has all but promised fresh stimulus when policymakers meet on Sept. 12, one of the last measures ECB chief Mario Draghi can take before stepping down on Oct 31.
"The ECB has a broad tool kit at its disposal and must stand ready to act," Lagarde said in written answers to the European Parliament's committee on economic affairs.
"While I do not believe that the ECB has hit the effective lower bound on policy rates, it is clear that low rates have implications for the banking sector and financial stability more generally," she added.
While Lagarde's appointment as ECB president from November is still to be confirmed, the process is largely a formality as euro zone leaders, who make the final call, are united in their backing of her nomination.
The ECB is expected to cut rates deeper into negative territory in September, restart asset purchases and compensate banks for the side effects of negative rates.
But economists say that these are relatively modest measures that will preserve easy financing conditions rather than give the economy a fresh boost.
Tempering expectations, Dutch central bank chief Klaas Knot, a prominent hawk of the 25-member Governing Council, said he was open to a rate cut but saw the resumption of asset buys as premature.
"If deflation risks come back on the agenda then I think the asset-purchase programme is the appropriate instrument to be activated, but there is no need for it in my reading of the inflation outlook right now,” Knot told Bloomberg on Thursday.
Lagarde, who is not expected to significantly alter the policy direction set by Draghi, also noted the limits of monetary policy, especially when the central bank has already used many of the unconventional tools at its disposal.
"The ECB is faced with a growing number of structural challenges and will also have to manage expectations about what it can and cannot do to maintain trust in policies," she said.
"While monetary policy is an effective tool for stabilising the economic cycle, it cannot lift countries’ longer-term growth potential," she added.
Still, she added that the current highly accommodative policy stance will be needed for "some time".
Lagarde added that it would be appropriate for the ECB to have a broader strategy review given how monetary policy has changed since the global financial crisis of 2008.
"As quite some time has passed since the last strategy review in 2003, it would be worth collecting lessons from the financial crisis as regards changes in the macroeconomic environment and inflation process," she said.
Warning about the risks from Britain's exit from the European Union, she also noted that a no-deal Brexit could lead to substantial financial market volatility and increases in risk premia.