* ECB’s Mersch snubs rate cut talks, says ECB has own compass
* Says ECB determined to prevent market dysfunction
* Bonnici sees liquidity support more important than rates
* Nowotny says interest rate cuts cannot be excluded
* Sees downward revision of ECB staff growth projections (Adds Bonnici, Knot, background, analyst)
By Sakari Suoninen and Martin Santa
FRANKFURT, Sept 26 (Reuters) - Speculation of a sharp cut in euro zone interest rates next month is “wild”, European Central Bank policymaker Yves Mersch said on Monday, but colleague Ewald Nowotny said cuts could not in general be ruled out.
European stock markets surged on Monday on the idea that the bank could slash its 1.5 percent main rate by a half-point on Oct. 6, taking back rises it made earlier this year in a bid to dig the European economy out of a deepening crisis.
There are substantial barriers to it doing so, however, not least that the meeting would conclude ECB President Jean-Claude Trichet’s term of office with a dramatic U-turn.
“These wild expectations only show that some people have lost the north,” Mersch told news agency Market News International in an interview conducted on Saturday, asked about interest rates.
“We have one needle in our compass.”
The phrase is often used by ECB policymakers to refer to them abiding by the central bank’s mandate of keeping inflation below, but close to 2 percent. Euro zone inflation stood at 2.5 percent in August although it is expected to drop off over the policy horizon the bank uses to guide rate decisions.
European policymakers have begun working on new ways to stop fallout from Greece’s near-bankruptcy from inflicting more damage -- some fear the fallout could match or exceed that of the 2008 collapse of Lehman Brothers.
ECB officials signalled on Friday that the bank could be set to restart to offer banks 12-month funds in its liquidity operations to help banks struggling with their fund-raising.
Analysts read Nowotny’s comments as opening the door to a cut in headline rates as well -- although his language used neutral wording policymakers often use to avoid giving a clear steer and gave no indication of timing.
“The ECB never pre-commits, and rate cuts cannot be excluded,” Nowotny, who also heads the Austrian National Bank, told news agency Market News International.
“It all depends on the developments ahead.”
Mersch also said the ECB would do whatever it takes to keep money markets functioning properly, echoing the bank’s readiness to reintroduce more of the emergency steps it took to help banks after the 2008 crisis.
Another Governing Council member, Malta’s Josef Bonnici, said that it was more important for the ECB to provide sufficient liquidity to banks than argue about interest rates.
“I think more than interest rates ... the provision of liquidity and funds to the banking sector is probably of more significance at this stage,” Bonnici told MNI.
Analysts said the rate comments revealed a deep split at the central bank and a vote might be the only way to square the circle.
“I think this is one of those situations where genuinely the Council will meet and review data that are coming up,” Societe General economist James Nixon said.
“I think that more so probably than at any other time in the ECB history, this is a situation where it probably will come down to a harsh vote.”
The ECB traditionally favours a consensual mode of decision-making where voting is shunned. But with views on growth and the chance of a recession also varying, differences are big.
While the economic situation has deteriorated, putting downward pressure also on inflation, the ECB’s official line at the start of September was that it is less optimistic than before but still expects moderate-paced growth in the euro area.
Executive Board member Juergen Stark on Saturday became the first of the bank’s top policymakers to suggest the euro zone could fall back into recession ) and Ireland central bank Governor Patrick Honohan backed up the gloom in a Reuters interview, pointing to the sharp slide in growth.
“We constantly monitor developments, but they (growth numbers) have been constantly below expectation over the recent weeks and months,” he said.
Honohan would not comment on interest rates, but said that he saw inflation falling comfortably below the ECB’s target.
Germany, euro zone’s biggest economy, saw a further decline in business sentiment, the closely-watched Ifo indicator showed on Monday, although the numbers were a touch better than expected.
Bundesbank President Jens Weidmann dismissed talk of Germany falling into a recession, and said the situation was not as bad as current mood suggested.
“If they continue to see a gradual recovery there is no reason to contemplate a cut in interest rates,” SocGen’s Nixon said.
“Given the problems they face, which are essentially the ones of liquidity, there are other instruments for a more appropriate fight-back, such as a reintroduction of 12-month tenders.”
One major barrier to a rate cut could be the ECB’s change of guard. Trichet’s eight-year term at the helm of the 17-country bloc’s central bank ends next month, and reversing the interest rate increases could be seen as an admission that he made a big mistake when starting to raise rates.
The International Monetary Fund’s European department head said it would support an ECB interest rate cut as euro zone growth is slowing sharply while there are practically no inflation expectations.
The Governing Council is also deeply split over its bond-buying programme, with Bundesbank President Jens Weidmann leading the charge to end the operations, although the purchases are supported by majority of policymakers. (Reporting by Sakari Suoninen and Martin Santa, additional reporting by Sylvia Westall in Vienna; Editing by Patrick Graham)