* Asset buys seen extended but cut
* Could halve bond buys
* May extend bond purchases by 9 months
* Decision at 1145 GMT
By Balazs Koranyi and Francesco Canepa
FRANKFURT, Oct 26 (Reuters) - The European Central Bank is all but certain to cut back on its bond-buying stimulus on Thursday, taking its biggest step yet in unwinding years of loose monetary policy.
It can do so because the euro zone’s economic recovery is now well into its fifth year. It also coincides with other major central banks - in the United States and Britain, for example - preparing to raise interest rates.
But the ECB is still bothered about low inflation. So it is expected to twin the cut with an extension of the programme — essentially a less-but-for-longer move.
Policymakers from the 19 euro zone countries are seen cutting monthly bond purchases by half in a nod to the rapid growth, a move towards dismantling the unprecedented measures that held the currency bloc together after back-to-back recessions.
Yet because inflation, the ECB’s single focus, remains far below target, any move is expected to come with a lengthy extension, a signal that support, even if diminished, could continue for years to come.
Indeed, sources close to the discussion said the debate was focusing on extending bond purchases by nine months with volumes cut perhaps by half from the current 60 billion euros, while at the same time reaffirming a commitment to keep rates steady until well after the purchases end.
The biggest debate is likely to be whether the ECB should signal its intent to exit the scheme, commonly known as quantitative easing, or keep it open ended so its could consider yet another extension next year.
Designed nearly three years ago to stave off deflation, the ECB’s 2.3 trillion bond buying scheme has cut funding costs, reviving borrowing and spending with the ultimate aim of generating inflation.
Hawks like Germany and the Netherlands now want a commitment to end these buys, arguing that more purchases do next to nothing for inflation. Doves on the bloc’s periphery meanwhile warn that a rapid exit could tighten financial conditions, undoing years of work.
“We think the ECB will keep a bias to buy more and/or for longer, if needed, to respond to any adverse development in the inflation outlook – in particular, any unwarranted tightening in monetary conditions stemming from the euro,” Luigi Speranza, an economist at BNP Paribas said.
The broader outlook is as good as it has been since before the global financial crisis. An unbroken growth streak has created 7 million jobs and the expansion is now self-sustaining, driven by domestic consumption.
Banks are better capitalised, lending is growing and divergence between the core and the periphery, the biggest failure of currency project, appears to have halted.
Yet inflation will miss the ECB’s target of almost 2 percent at least through the decade as labour market slack remains large, keeping a lid on wages and supporting the case for continued support.
Still, the ECB is slowly running out of bonds to buy in some countries, suggesting that market constraints will play an increasingly large role in the policy debate as a major redesign of rules risked sending the wrong signal when the bank is working on an exit strategy.
While a nine-month extension at a reduced pace is viable under current rules, another move could require more creativity as the ECB would be running low on German bonds to buy, a hurdle since purchase need to match the so called capital key, each country’s relative size in the euro zone.
“Our work suggests that there’s scope to buy beyond September 2018,” Morgan Stanley said in a note. “This will probably require an even more pronounced deviation from the capital key and/or relying to a greater extent on the corporate bond-buying programme.”
To pave the way for the eventual end of bond buys, the ECB is likely to increase its emphasis on conventional tools, such as interest rates, which are not seen rising until 2019, at the earliest.
It will also focus more on reinvestments from maturing debt and the support provided by its oversized balance sheet, shifting communication away from flows.
It could also take some pressure off government bond purchases by increasing the share of corporate and covered bond buys in the scheme, funnelling a bigger share of its cash to the private sector rather than government bond markets.
The ECB announces its policy decision at 1145 GMT, followed by ECB President Mario Draghi’s news conference at 1230 GMT.
Reporting by Balazs Koranyi Editing by Jeremy Gaunt.