FRANKFURT European Central Bank President Mario Draghi faces intense pressure from investors, European leaders and even the United States to deliver on Thursday on his pledge to do whatever it takes to save the euro.
Draghi will face the biggest test of his nine months' leadership of the central bank when it meets later in the day, and any signs that he overplayed his hand when making the pledge a week ago could see markets punish the euro zone.
The ECB has little margin for error to maintain its credibility and avoid bond yields climbing in the indebted countries on the euro zone periphery.
The market's faith in Draghi will be tested before the 1230 GMT post-meeting press conference by a Spanish bond auction that could see its debt costs rise.
"Draghi has unfortunately painted himself into a corner," JP Morgan analyst Pavan Wadhwa said in a conference call.
"The ECB does need to demonstrate its credibility ... Otherwise Draghi will lose face completely."
While central bank sources have told Reuters that bold action is probably at least five weeks away, Draghi may offer some clues on what is in the offing. He said last Thursday that the political capital invested in the euro is often underestimated.
"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough," Draghi told an investment conference in London.
Spanish and Italian bond yields fell markedly after Draghi's speech, and inaction could send them higher again.
"We could see markets going back to where they were before last Thursday," said Nordea analyst Anders Svendsen, who expects more words but little concrete action from the meeting.
Other countries, especially the United States, have sought to raise pressure on the ECB to act. U.S. Treasury Secretary Timothy Geithner said the euro zone must take steps to bring down borrowing costs in troubled member states.
The ECB has already bought bonds through its Sovereign Markets Programme (SMP), spending more than 210 billion euros on them so far, and re-employing an existing tool would avoid the legal battles that any novel measures could face.
While the SMP is widely viewed as having had very limited success, it is at least available immediately and could be used in a new form, combining it with the EFSF bailout fund.
The ECB could use the SMP to buy bonds after Spain makes a formal request to the EFSF and also commits to reforms.
"Based on Draghi's comments a restart of SMP (or EFSF/ESM) buying appears the most likely response," Danske Bank's Allan von Mehren and Anders Moller Lumholtz said in a note.
ECB action is hamstrung by EU rules forbidding it to finance governments. The ECB issued a legal opinion in March 2011 ruling out perhaps the biggest gun, giving the ESM bailout fund rights to tap the ECB for funds to increase its firepower.
Draghi himself has argued against the move, but last week Governing Council member Ewald Nowotny broke ranks and said it could be advantageous to give the ESM a banking licence that would allow it to borrow. Some ECB watchers believe the move was a trial balloon sent up in coordination with the ECB leadership.
The ECB also has to find a way to get any measures past Germany, the euro zone's largest economy and its principal paymaster. The Bundesbank issues regular reminders of inflationary dangers stemming from non-standard measures such as bond purchases and the limits central banks face.
On Wednesday, the German central bank released an interview with Bundesbank President Jens Weidmann, where he said that "politicians overestimate the central bank's capacity and place too many demands of it".
The dilemma for Europe is that too little action now could create bigger problems later. If borrowing costs don't come down, forcing both Spain and Italy to seek aid, the ESM's 500 billion euro capacity would soon be depleted, and it would need more funds.
"I think that's a bridge that doesn't need to be crossed yet," JP Morgan economist David Mackie said in a conference call.
NO RATE CUT EXPECTED
Another tool at the ECB's disposal, lowering interest rates, is unlikely to be used again so soon after it cut its main refinancing rate to a record low of 0.75 percent in July. A Reuters poll showed that economists see another decrease in interest rates before the end of the year, but only seven out of 70 expected it to cut again this month.
As the crisis has intensified, the euro has taken a hit in foreign exchange markets. It has fallen about 15 percent in the past year to trade at $1.23. On a trade-weighed basis it trades at nine-year lows.
The falling euro is likely to delay the day when inflation falls below the ECB's target of 2 percent. In July, it remained at 2.4 percent. It also assuages fears of deflation, however, a spectre that could otherwise have prompted the ECB to consider large-scale bond buying.
"To move into large-scale asset purchases from purely monetary stance motivation will take a while," J.P. Morgan's Mackie said. "It's certainly not going to happen ... until we get into next year."
(Reporting by Sakari Suoninen; Editing by Will Waterman)