FRANKFURT Oct 29 (Reuters) - A rise in the euro to a two-year high is complicating the European Central Bank's policy puzzle, and Governing Council members are at odds over how to respond.
The appreciation is largely about dollar weakness due to U.S. Federal Reserve policy, but the outcome for ECB policymakers is concern that already subdued inflation will slow further and a nascent economic recovery will falter.
At only 1.1 percent, inflation is running well below the ECB's target of just under 2 percent and the currency's rise could depress price pressures even more, making it a live issue for the euro zone's central bankers.
Three strains of thinking appear to be running through the 23-man Governing Council, people familiar with the internal debate say. One is content to keep open the option of another round of long-term loans to banks, another favours an interest rate cut, while a third is prepared to sit this one out.
With markets now expecting the Fed will delay unwinding its bond-buying stimulus until next year, the euro has strengthened to its highest level since November 2011 and is up nearly 7 percent over the last three months at around $1.38, though that is way below the peaks above $1.60 it hit in 2008.
In an eBook on forward guidance published last week by policy research portal Vox, ECB Executive Board member Peter Praet underlined the ECB's potential to act: "We have not run out of ammunition," he said.
"Further cuts in policy rates remain an option for the ECB if the outlook on price stability so warrants."
The ECB's main interest rate is already at a record low 0.5 percent after a cut in May. Then, some policymakers wanted a bigger reduction, but in the end the Governing Council agreed to cut rates by 25 basis points.
The euro's buoyancy is not only against the dollar - on a trade-weighted basis it is also at its highest level in almost two years. This is starting to affect business.
Several large French companies, including insurer AXA , carmaker Renault and energy management firm Schneider Electric, partly ascribed disappointing results last week to euro strength.
Lowering interest rates could help by weakening the euro.
TALK BEFORE ACTION
But before any further cut, the ECB is likely to try to talk down the euro. ECB President Mario Draghi, who took office in November 2011, has used the strategy before, with some success.
In February, when the euro was almost as high as it is now, Draghi said the ECB saw its strength as a downside risk to inflation. Partly in response to that, the euro reversed course without the central bank having to take further action.
A rate cut, should there be one, might take months to come.
"The ECB will ramp up its verbal rhetoric at the next meeting due to the currency and possibly due to liquidity developments," JP Morgan economist Greg Fuzesi said in a note to investors.
The ECB holds its next policy meeting on Nov. 7.
Another way to ease policy would be to offer banks another round of long-term loans, known as LTROs, a ploy the ECB used in late 2011 and early 2012 to funnel more than a trillion euros ($1.4 trillion) into the financial system.
One ECB policymaker, speaking under condition of anonymity, said he was not sure an LTRO would be useful as liquidity is not a problem for many banks. Another insider said this option was more likely than a rate cut but was not imminent.
Draghi himself keeps mentioning the LTRO as an option, but other policymakers play down the chance of the ECB conducting one in the coming months, if at all, though the ECB is looking into the market impact the last round of long-term loans had.
While a persistent rise in the euro will strengthen the case for ECB action, the puzzle could solve itself should the Fed begin unwinding its stimulus early next year and the dollar start to rise. The ECB is watching developments closely.
Draghi said after the ECB's Oct. 2 policy meeting: "The exchange rate is important for growth and for price stability, and we certainly pay close attention to these developments."
French Industry Minister Arnaud Montebourg renewed his call on Tuesday for the ECB to ease monetary policy and implicitly blamed German policymakers for preventing it.
Calling for a 10 percent fall in the euro's value against the dollar, Montebourg said: "The currency doesn't belong to central bankers, the euro doesn't belong to Germany, it belongs to all the members of the euro zone."
However, French Trade Minister Nicole Bricq played down the importance of the exchange rate in France's economic problems, telling a Reuters Newsmaker Breakfast: "The euro must not be an excuse for our (loss of) competitive advantage ... We're the ones to have to find solutions to our competitiveness handicap."
Price stability is the main focus of central bankers.
The ECB already sees inflation increasing only modestly in the next two years. Staff projections put it at 1.3 percent next year. While the 2015 inflation forecast will be published only in December, an ECB policymaker said the central bank sees inflation below 1.5 percent in that year, too.
Euro strength could cut price pressures further to levels at which deflation could become a concern.
"This might push inflation to below 1 percent and should set off alarm bells," OP-Pohjola economist Reijo Heiskanen said. "There are some who question whether there is a case for further easing with the economy recovering, but with the increasing uncertainty, I see there is one."
JP Morgan calculates a 10 percent currency shock crimps GDP by 1 percent, with most of this felt within two years, and that the annual inflation rate is lowered by 0.3 percentage points for two years.
The ECB said in July it expected to keep rates at current or lower levels for an extended period of time, maintaining a downward bias. Despite this 'forward guidance', few investors have believed that another rate cut could be in the works. But their thinking is changing.
Last time, when analysts expected the ECB to hold rates, Draghi said the Council discussed a rate cut before holding fire. It will surely do so again.