FRANKFURT (Reuters) - The European Central Bank is closer to lowering interest rates than at any time since it last cut them in July 2012 and is likely to shave a quarter-point off at its policy meeting next week.
Senior sources involved in the deliberations say momentum is building for action to help a euro zone economy which has slipped back into recession, a move that some policymakers wanted to take earlier this year.
Inflation sliding well below target gives the bank scope to act and a senior ECB official said even Bundesbank chief Jens Weidmann, the most hawkish member of the 23-man Governing Council, had an open mind.
After the bank's last monetary policy meeting on April 4, ECB President Mario Draghi signaled that a cut could come soon when he said that the bank stood "ready to act" to boost the recession-hit euro zone economy.
"Now we are free," one senior ECB official said. "For the next meeting in Bratislava, I would look at rates, certainly."
The ECB's Governing Council meets in Bratislava next Thursday - one of two annual policy meetings outside Frankfurt. The 23-man body rarely moves rates when it meets off-base, but the bleak economic picture strengthens the case for action.
Any decision on whether to act in May will depend on the economic data. Benoit Coeure, a dovish member of the ECB's core group of policymakers, said on Monday the bank had not seen data pick up since its last rate decision.
The ECB expects a gradual recovery in the euro zone in the second half of this year, "subject to downside risks".
Figures indicating the economy's performance will be weaker than that scenario would strengthen the case for a rate cut.
"If they confirm (the scenario), does that mean we don't cut the rate? Not necessarily," the senior official said.
Policymakers believe a rate cut would have limited impact on the economy but would at least show they are supporting it. A decision to cut could well not be unanimously supported.
The case for easier policy was boosted by Tuesday's purchasing managers' indexes, which the ECB watches closely, which showed a sharp drop in German business activity in April.
That marked the fourth time the German Composite PMI has fallen below 50, into contractionary territory, since September 2008. On the previous three occasions, an ECB rate cut has followed immediately after publication of the final data, or the month after.
Germany's closely-watched Ifo business climate index tallied with the PMI on Wednesday, falling more than expected in April. An ECB survey also showed demand for corporate and household loans in the euro zone plummeted in the first three months of the year.
Any interest rate move is likely to focus on the ECB's main refinancing rate, with a cut in the deposit rate the ECB pays banks for holding their cash overnight far less likely.
The main refinancing rate already stands at a record low of 0.75 percent, though this is higher than the policy rates of the other major global central banks.
"The German slowdown, the very low inflation rates we have in Germany, the latest decline in the oil price - all these factors are weighing on inflation and should make even the Bundesbank a little less opposed to a rate cut," said Berenberg Bank economist Christian Schulz, though he expected the ECB to hold off for now.
Cutting the refinancing rate would help banks in the euro zone periphery that borrow sizeable amounts from the ECB, though the impact this would have on their lending activity is unclear.
"It's not clear whether banks would use the full 25 basis points to lower their lending rates, or take it as profit and use that to build up their capital," said one expert familiar with the ECB's operations. "I think either would be positive."
Draghi said after the ECB's April 4 meeting it was essential that the "resilience of banks (be) strengthened where needed".
While a rate cut would show the ECB is ready to support the economy, the bank believes it would have only limited impact because its ultra-low interest rates are not reaching all euro zone economies evenly, with lenders in crisis-hit countries passing on higher funding costs to their customers.
Related to this, ECB policymakers are looking at their liquidity provision to banks. The ECB flooded banks with more than 1 trillion euros in two long-term refinancing operations (LTROs) in late 2011 and early 2012 to avert a credit crunch.
Banks have already repaid early more than a quarter of the funds - a development the ECB sees as positive as it shows they are ready to stand on their own feet.
Repayment of these LTROs has driven down excess liquidity in the euro zone - the level of cash beyond what banks need to cover their day-to-day operations - to some 330 billion euros from above 600 billion at the start of this year.
But in the event of another shock to the financial system it is unclear exactly what the ECB would do.
Draghi said on April 4 "our monetary policy stance will remain accommodative for as long as needed" and that banks would be provided with unlimited liquidity "for as long as necessary".
Though the ECB is unlikely to follow the U.S. Federal Reserve's example and give guidance on rates -- the Fed expects to keep them near zero until unemployment drops to 6.5 percent or so -- it could flesh out its commitment on providing liquidity to try to boost banks' confidence.
"Maybe we could be a little more specific on 'as long as needed'," the senior ECB official said.
(Additional reporting by John O'Donnell, editing by Mike Peacock)