MONEY MARKETS-Interbank rates edge higher as ECB meeting nears

* Interbank lending rates edge up, rate hike theme dominates

* Hawkish ECB expectations create risk of correction

* Banking liquidity improves despite emergency lending fall

By William James

LONDON, Feb 25 (Reuters) - The benchmark cost of interbank
euro lending rose on Friday as expectations the ECB would signal
next week it is moving closer to tightening policy outweighed
the effect of a short-term improvement in banking sector
liquidity.
The European Central Bank meets to discuss policy on March 3
and markets are expecting the bank to step up its language on
measures to tackle inflation after a wave of hawkish comments
from members of the bank this month.

Despite a rise in surplus banking sector liquidity, the
three-month Libor rate EUR3MFSR= rose for a fourth consecutive
day to 1.04625 percent and the equivalent Euribor rate
EURIBOR3MD= climbed to 1.092 percent.

"This move is driven by rate hike expectations in the market
and not so much by the liquidity situation," said Elwin de
Groot, senior market economist at Rabobank.

Data released earlier in the session added to the growing
concern over rising prices, showing inflation accelerated in
five German states during February, buoyed by soaring energy
costs. [ID:nLDE71O0FI]

Interest rate futures showed a 25 basis point rate hike in
the euro zone was fully priced in by Aug. 4, with a 73 percent
chance of a hike coming as early as the ECB's July 7 meeting.
ECBWATCH

In the runup to the ECB meeting, analysts said the high
market expectation of escalating inflation-fighting language
meant that risk to current price levels was skewed.

"There is some room for downward surprises, I would expect,
given all of the expectations that are priced in," de Groot
said.

LIQUIDITY IMPROVES

Liquidity conditions in the banking sector, which add to
upward pressure on overnight rates when worsening, showed a
slight improvement against the previous day's level.

The recent exceptionally high usage of the ECB's emergency
overnight borrowing facility fell by 12.7 billion euros after
Ireland's High Court approved the sale of deposits from Anglo
Irish Bank and Irish Nationwide on Thursday. [ID:nLDE71N2BF]

The pending sale of the assets had forced the banks to
borrow at the more expensive overnight rate since last week,
rather than using the ECB's weekly refinancing operations.

The reduction in emergency lending would typically cause a
decline in excess liquidity, but an unexpected fall in the ECB's
benchmark 'autonomous factors' calculation of the banking
system's funding needs more than offset the move.

"The two factors cancel each other out so liquidity surplus
increased to 28 billion from 20 billion ... liquidity conditions
have not worsened so I don't see a strong impact on Eonia," said
Giuseppe Maraffino, strategist at Barclays Capital.

The Eonia overnight rate EONIA= edged higher to 0.666
percent, but with banks well ahead of their reserve maintenance
requirements, more cash was likely to be freed up in the coming
week, also helping keep a lid on further rate rises.

Analysts said the fall in the liquidity benchmark was
probably linked to an increase in aid (Emergency Liquidity
Assistance or ELA) provided by the Irish central bank.

"This is really quite a change in autonomous factors and it
is not consistent with the ECB predictions published last Monday
... so I suspect there is also some use of ELA borrowing,"
Maraffino said.
(Editing by Susan Fenton)