ECB seen taking tentative step to prop up ailing euro zone

The European Central Bank will slash growth forecasts on Thursday and is likely to provide its strongest signal yet that fresh stimulus is coming in the form of more cheap loans, hoping to stop an unexpected slowdown from becoming a downturn.

With a global trade war and Brexit uncertainty scarring the euro zone economy, business confidence has turned negative, raising the risk that recession fears become self-fulfilling and spread from Germany and Italy to the rest of the bloc. That leaves the ECB with the familiar role of having to prop up sentiment and President Mario Draghi will oblige, albeit with small steps initially.

Such a move is certain to be seen as a policy reversal. The ECB only ended quantitative easing, its biggest stimulus scheme to date in December, and has signalled an interest rate hike for later this year. But central banks around the world are reversing course, led by the U.S. Federal Reserve, which has signalled a pause in rate hikes and said it will stop shrinking its balance sheet -- a boon for stock investors.

The ECB's first port of call will be to offer banks fresh liquidity to keep credit flowing to corporate borrowers. It will then formally delay a rate hike, which markets do not expect until well into 2020. The first of those steps is likely to come on Thursday, even if not all the details will be announced. A change in forward guidance on interest rates is not seen just yet as the ECB is expected to stagger its moves to achieve maximum impact.

The bank's decision is due at 1245 GMT while Draghi's news conference is scheduled for 1330 GMT. The problem is that with industrial output and exports shrinking, commercial banks already seem to be restricting credit, threatening to reinforce the slowdown.

Fresh central bank loans, called targeted longer-term refinancing operations, or TLTROs, could prop up bank lending and more importantly, help banks roll over a previous facility. The ECB fears that if banks start to repay these loans, due to expire next year, its balance sheet will quickly shrink, automatically tightening policy just as the economy needs a bit of extra support.

For an EXPLAINER on the TLTROs, click For a FACTBOX with policymakers' recent comments, click

BANG FOR THE BUCK? But much of the slowdown is imported and thus outside the ECB's control. It also has a limited policy arsenal given years of stimulus and rates still deep in negative territory.

"While the ECB still has some ammunition left, its arsenal lacks 'easy', cost-free options," BNP Paribas said in a note to clients. "Recent data have challenged the ECB view that the ongoing slowdown was mainly due to temporary factors, soon set to fade," it added. "In fact, the deterioration in the macro outlook appears to be broader and more prolonged than the central bank had envisaged originally."

But the ECB has so far stuck to the narrative that the growth dip is temporary and many of the culprits for it will no longer be around after the spring. Indeed, some recent indicators seem to be showing tentative signs of stabilisation, supporting the case for ECB caution.

The ECB will publish its quarterly staff economic projections on Thursday. Growth is expected to slow to 1.3 percent this year, from 1.8 percent a year ago, a Reuters poll of analysts showed, with only a small rebound seen for next year. More worryingly, inflation is seen holding well short of the ECB's target of almost 2 percent for years to come, suggesting the bank will keep on missing its objective well into the next decade.

"The fact that the ECB cannot change many of the reasons for the current weakness of the euro zone economy with an even looser monetary policy also speaks in favour of a rather restrained effect of further monetary policy measures," Commerzbank economist Michael Schubert said. "In view of negative interest rates, record excess liquidity and the nature of the current problems, the impact (of further measures) may only be minor," he added.

(Editing by Catherine Evans)

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