FRANKFURT The European Central Bank is in a policy no man's land, bombarded by news of a stagnating euro zone economy but hesitant to move forward with new stimulus until measures it loaded in June have ignited.
After the ECB cut interest rates in June and promised banks cheap long-term loans starting in September, about all that is left is printing money to buy bonds - so-called quantitative easing (QE).
But there are tricky practical and political barriers in the ECB's way: it is boxed in by its own plans, and still faces strong opposition from economic power Germany to any such monetary leniency.
Already deployed by other major central banks, QE could be used to pump money into the euro zone economy with a view to stimulating growth and staving off deflation, which has already gripped some countries in the bloc's south.
At just 0.4 percent, euro zone inflation is in what the ECB considers a "danger zone". Economic growth, meanwhile, ground to a halt in the second quarter even before the bloc has started to feel the impact of sanctions on and by Russia over Ukraine.
Yet the ECB may be in a wait-and-see mode for some time, waiting until the measures it announced in June kick in. The first tranche of long-term loans it is offering banks to stimulate lending, called TLTROs, is not available until Sept. 18, with a second shot in December.
"What is happening in geopolitics is tilting the balance toward having to implement further stimulus," said Andrew Bosomworth, a senior portfolio manager at Pimco, the world's largest bond investor.
"But I think there are a few things in the pipeline on the positive side that we can point to as well, so we'd put a fifty-fifty chance on QE right now, which brings me to the conclusion that the ECB is in observe-and-analyse mode for now."
On the plus side, while the economy had no growth in the second quarter, euro zone banks in the same period did ease lending terms for firms for the first time since the start of the financial crisis.
And as well as TLTROs, the ECB is also intensifying preparations to buy asset-backed securities (ABS), which are created by banks pooling loans into an interest-bearing bond that is sold to raise funds.
The ABS market has not recovered following the global financial crisis, but the ECB hopes that by supporting this segment it can get credit to the smaller firms that make up the backbone of the euro zone economy.
Any ABS plan is likely to be small, but the ECB expects take-up of 450-850 billion euros ($601 billion-$1.13 trillion) for the TLTROs, potentially more than the total annual GDP of the Netherlands.
However, despite the queued-up stimulus, improving credit conditions and the prospect of a more robust banking sector thanks to upcoming health checks, France and governments further south want the ECB to do more to buoy their economies, which they have been unable - or unwilling - to shape up.
"I am convinced that more can be done and I'm also convinced that the ECB is getting ready to do more," Italian Economy Minister Pier Carlo Padoan told the BBC at the weekend.
Indeed, a Reuters poll of euro money market traders gives a 50 percent chance that the ECB will resort to QE-style asset purchases to boost inflation in the coming year. [ECB/REFI]
But waiting for evidence that what it has done is working is only part of the ECB's QE dilemma. Some policymakers believe QE is inappropriate; others are not sure it would work anyway.
Hawkish ECB policymakers are still deeply resistant to the idea. For example, ECB Executive Board member Sabine Lautenschlaeger, a former member of Germany's Bundesbank, said last month it needed a "real emergency" for a broad asset-buying plan to be deployed.
"Technically there are quite a few people in Frankfurt who are not absolutely sure QE would have a significantly positive impact on growth," said Deutsche Bank economist Gilles Moec.
Some euro zone officials argue the ECB would need to spend huge amounts on a broad asset-buying plan to have any impact, and that this would probably only be marginal as sovereign bond yields are already near historic lows.
There is also the issue of what to buy. In the United States, where the economy is based on capital markets, Federal Reserve purchases of U.S. Treasuries and mortgage-backed bonds had an impact across asset prices, holding down borrowing costs.
But in the euro zone, the economy is based on bank lending, so buying sovereign bonds may not be as effective. ECB Executive Board member Benoit Coeure said earlier this year any euro zone QE plan would have to be tailored to the bank-based economy.
Buying sovereign bonds according to the ECB's capital key - the share each euro zone country's central bank has in the ECB's capital, based on the size of its economy - would see large purchases of German bonds, the merits of which are questionable as their yields are already near record lows.
Padoan, the Italian economy minister, acknowledged this: "Quantitative easing has worked well in the U.S.... but of course the underlying economic structure of the U.S. economy is largely different from the still-fragmented euro area."
Policy developments across the Atlantic could actually play into the ECB's hands. While the ECB considers how to loosen policy, the Fed has started reining in its expansive tools and is preparing to raise interest rates, perhaps in mid-2015.
A recent Reuters poll of 74 analysts showed the Fed is not likely to raise rates until the second quarter next year, most likely in June. Interest rate futures are pricing the first rate hike in the third quarter of next year. [FED/R]
"The ECB would jump for joy," said Hans Redeker, global head of foreign exchange strategy at Morgan Stanley, referring to the implied dollar strength that such a step would bring with it.
"This would also mean euro weakness and that is exactly what the ECB wants. It would ease pressure, because further steps from the ECB would be less necessary," he said, adding exports, especially from the periphery, would become more competitive.
An ECB pledge to keep interest rates at present levels for an extended period of time is also seen stabilising the situation in such an event.
A weaker exchange rate may be more effective at generating growth than ever more liquidity that struggles to find its way to companies and households as banks remain reluctant to lend while tidying up their balance sheets.
The euro has weakened more than 4 percent since scraping by the $1.40 mark in May. But it is still too strong for some periphery countries, such as Italy.
Morgan Stanley calculated what it called a "fair exchange rate", at which a country would be able to maintain a sustainable trade balance and an exchange rate that would not have a long-term negative impact on growth conditions.
Italy's fair exchange rate would be $1.20 and Germany's $1.53, Redeker said, showing how diverse the economies are.
($1 = 0.7492 Euros)
(Editing by Jeremy Gaunt)