UPDATE 3-ECB toughens talk, holds off fresh action for now

Thu Jan 9, 2014 11:50am EST

* ECB "strongly emphasises" policy will remain accommodative

* Draghi says firmer words strengthen forward guidance

* ECB key rate unchanged at 0.25 percent

* Draghi says euro zone may face prolonged low inflation

* Says doesn't see Japanese-style deflation in euro zone

By Eva Taylor and Sakari Suoninen

FRANKFURT, Jan 9 (Reuters) - The European Central Bank on Thursday forcefully underlined its determination to take action should euro zone inflation risk turning into deflation or rising money market rates threaten the bloc's fragile recovery.

After leaving interest rates at a record low on Thursday, the ECB toughened its pledge to keep its policy loose, "firmly reiterating" its expectation for rates to remain at current or lower levels for an extended period.

"The Governing Council strongly emphasises that it will maintain an accommodative stance of monetary policy for as long as necessary," ECB President Mario Draghi said after the decision to leave the main interest rate at 0.25 percent.

The rate decision was widely expected and came after news earlier this week that euro zone inflation slowed to 0.8 percent in December, a development Draghi blamed on a one-off technical quirk in German service sector figures.

The central bank's last policy action was to shave its main rate to 0.25 percent in November.

Draghi, stressing that "we have several instruments that we can use", acknowledged that the ECB had used stronger language this month than previously and identified two scenarios that could trigger fresh policy action.

"One is unwarranted tightening of the short-term money markets and the other one is a worsening of our medium-term outlook for inflation," he told a news conference.

The euro initially fell on the more dovish ECB tone before recovering as Draghi said it was pointless to speculate what instruments the ECB might use next as it would depend on which scenario unfolded.

He would not be drawn on the possibility of outright purchases of securities similar to the quantitative easing policies of the U.S. Federal Reserve, the Bank of England and the Bank of Japan, saying only that the ECB could do whatever its treaty mandate allowed.

JP Morgan economist Greg Fuzesi said that with both the scenarios Draghi identified that could prompt action "it remains very unclear where the ECB's trigger points lie."

"Overall, we continue to think that the ECB is on hold, despite the uncomfortably low level of inflation," Fuzesi said. "We also think that a large shock would be needed to trigger a significant response, rather than an incremental one."

DANGER ZONE

Draghi had said in a magazine interview published last week that the ECB must be careful not to slip into a "danger zone" of inflation rates entrenched below 1 percent.

The dip in inflation in December had fed concerns among some ECB watchers about deflation taking hold in the euro zone.

In Greece, annual inflation is already running at minus 2.9 percent. However, Draghi drew a distinction between deflation as a protracted fall in prices and necessary internal price adjustments in some euro zone countries.

"Right now, we don't see deflation," he said. "By and large we don't see a deflation in the Japanese sense of the 1990s."

With policy rates so low and the ECB's toolbox depleting, the threshold for further policy easing has risen, even as the central bank worries about slow price rises.

Low inflation is not the central bank's only concern. A lack of lending and receding excess liquidity - the amount of money in the market on top of what banks need for their day-to-day operations - are adding to its dilemma.

Excess liquidity - the money from ECB loans - almost halved overnight to 157 billion euros ($213.53 billion) as banks took up fewer funds from the ECB, which has reduced liquidity further by offsetting its bond purchases.

Early repayments of three-year central bank loans resume next week, meaning even more funds will be siphoned out of the markets, helping push money market rates up more.

Draghi has repeatedly said banks returning money to the ECB is a positive sign and has said interbank markets are working better. But if banks hoard less cash, borrowing costs rise.

Lending to companies in the bloc shrank at the fastest pace on record in November and the difference in corporate loan costs around the bloc grew. This suggests the ECB's low rates are still not filtering into all countries.

Nevertheless, Draghi said confidence was gradually returning to the euro zone economy and the central bank's very accommodative monetary policy stance was finally finding its way into the real economy.

He stopped short of saying the euro zone crisis is over.

"The recovery is there but it's weak, it's modest and as I said many times, it's fragile meaning that there are several risks from financial to economic to geopolitical to political risks that could undermine easily this recovery," he said.

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