FRANKFURT The European Central Bank doused hopes on Thursday it will ramp up its bond-buying program to fight the bloc's debt crisis, unnerving markets hours before a high-stakes EU summit they had hoped would produce a 'grand bargain' to end the turmoil.
The ECB cut rates to a record low of 1.0 percent, offered ultra-long 3-year financing to banks and eased rules on the collateral it requires from banks to tap its funds.
But by playing down expectations the bank would boost its bond purchases, ECB President Mario Draghi disappointed markets hoping it would aggressively ramp up its crisis response if euro zone leaders agree tougher budget rules at the summit.
"One step forward, two steps back," said Alan Clarke, economist at Scotia Capital. "The ECB thought it was helping out by cutting interest rates and providing longer term liquidity measures. So far so good.
"But then to dash any hopes that the ECB might fire its bazooka (and engage in QE) has meant that the ECB's actions have backfired ... The euro zone leaders might as well not bother. Pack their bags, go home, enjoy the weekend and do their Christmas shopping."
Draghi said new forecasts from the central bank showed the currency bloc's gross domestic product could contract by as much as 0.4 percent next year although it could also grow by as much as 1.0 percent.
Despite the threat of recession, he revealed the vote to cut rates was not unanimous.
"The outlook remains subject to high uncertainty and substantial downside risks," Draghi told a news conference.
The EU summit will seek agreement on how to defuse the crisis, with France and Germany pushing for rule changes to enforce stricter budget discipline in the bloc.
The ECB, which euro zone officials say has been closely involved in drafting plans for tighter fiscal integration, has pressed governments to toughen their budget rules.
Draghi heightened expectations last week that the ECB could do more to fight the crisis by saying "other elements might follow" if European leaders agree tighter budget controls first.
ECB watchers took that to mean the central bank would step up its purchases of the bonds of struggling euro zone members but he firmly played down that interpretation.
"I was surprised by the implicit meaning that was given (to my comments last week)," Draghi said.
"A new fiscal compact, comprising a fundamental restatement of the fiscal rules together with the fiscal commitments that euro area governments have made, is the most important precondition for restoring the normal functioning of financial markets."
The euro turned negative in response and Italian government bond yields rose.
"This is big -- a lot of people, stocks, bonds, currencies, had been counting on the ECB and he's basically pulled the rug out from under the market," said Brian Dolan, chief strategist at Forex.com in New York.
With euro zone leaders desperate to build a firewall around their debt-ridden economies, another idea that has been floated is for euro zone central banks to lend to the International Monetary Fund so it could take a more prominent role.
"It's legally complex. The spirit of the treaty is that one cannot channel money in a way to circumvent the treaty provisions," Draghi said. "If the IMF were to use this money exclusively to buy bonds in the euro area, we think it's not compatible with the treaty."
The rate cut was aimed at buoying the euro zone economy, which economists expect to slide into recession by early 2012.
A Reuters survey of 73 analysts had shown a 60 percent chance the ECB would cut rates by 25 basis points for the second month running, back to the record low of 1.0 percent it reached during the financial crisis in 2009.
Inflation is now forecast to be in a range of 1.5-2.5 percent next year. The ECB's target is close to but below two percent.
3-YEAR BANK SUPPORT
Draghi also said the ECB would start offering banks funding for 3 years for the first time ever, to try to prevent the crisis from precipitating a credit crunch that would choke the bloc's economy.
Draghi, who took over the reins from Jean-Claude Trichet last month, said a 36-month refinancing operation on December 21 would replace the 12-month funding offer the ECB had planned previously.
The ECB would offer full allotment -- meaning it will meet all bids -- at the two three-year tenders planned and there would be an option of early repayment after a year.
It also made it easier for banks to get its funding by further expanding the menu of assets they can swap for ECB loans.
The ECB has already reinstated some of its most potent crisis-fighting tools in recent months in a bid to calm escalating tensions in bank-to-bank lending markets. Last week it, the U.S. Federal Reserve and a clutch of other top central banks slashed the cost of the dollar loans they offer banks.
But the apparently cool attitude to stepping up its bond-buying program is likely to overshadow that assistance.
France and Italy but also the United States and Britain have all put intense pressure on the ECB to use its potentially unlimited firepower to calm the euro zone's crisis which is now casting a dark cloud over the global economy.
Earlier this week ratings agency S&P warned that its threat of a mass downgrade of euro zone members would be tough to avoid if larger ECB bond buying was not part of Friday's summit deal.
Pressure is getting ever more intense on the central bank to avert a euro zone meltdown.
A senior euro zone source said hours before the start of the EU summit that a proposal to give the euro zone's permanent bailout fund, the European Stability Mechanism, a banking license - which could allow it to access ECB funds, boosting its firepower - had been rejected.
The ECB had been uncomfortable about the idea but the jettisoning of another proposal that could have put a firewall around euro zone debt strugglers leaves it ever more firmly in the spotlight to act directly.
"Whereas we need to withhold judgment until the weekend is over, Draghi's comments so far more than back up our base case: the euro crisis may have to get worse in early 2012 until the ECB realizes that it has to counteract the risk of a deflationary collapse of the euro zone by much more forceful action," said Berenberg Bank economist Holger Schmieding.
(Reporting by Marc Jones/Paul Carrel; writing by Mike Peacock; editing by Chris Pizzey/Ruth Pitchford)