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UPDATE 2-ECB to buy euro zone govt bonds to fight crisis

* ECB to buy government bonds for first time

* Says steps justified by budget promises

* Bond purchases to be sterilised to offset liquidity

* Brings back 6-month liquidity operation, dollar lending

* ECB text [ID:nLDE6450VF] (Adds analyst comment, market reaction)

By Krista Hughes and Sven Egenter

BASEL, Switzerland, May 10 (Reuters) - The European Central Bank will buy euro zone government bonds to help support fractured markets, abandoning resistance to full-scale asset purchases in light of Greece’s debt crisis.

The ECB said in a statement that the step, dubbed the ‘nuclear option’ by many economists, was justified because of government promises to meet strict budget targets and step up consolidation efforts.

Boosting its firepower further, the ECB said it would also re-start dollar lending operations and bring back some of the emergency liquidity measures it had started to phase out.

“The European Central Bank decided on several measures to address the severe tensions in certain market segments which are hampering the monetary policy transmission mechanism and thereby the effective conduct of monetary policy oriented towards price stability in the medium term,” it said in a statement just after European Union finance ministers announced their own 500 billion euro crisis package. [ID:nLDE64900T]

The scope of the purchases is yet to be determined, but the ECB said they would be offset by liquidity-absorbing operations so that the stance of monetary policy is unaffected.

The euro rallied to just under $1.30 EUR=, futures markets pointed to a sharp rise in stock prices STXEc1.FTEU3 while Bund futures FGBLc1 eased.

Under the plan, agreed late on Sunday, the ECB will buy and sell both government and private bonds on the secondary market. [ID:nSGE64802Q]

“This truly is overwhelming force, and should be more than sufficient to stabilize markets in the near term, prevent panic and contain the risk of contagion,” said Marco Annunziata from UniCredit Group in London.

“Not only is the headline number stunning, but the ECB’s decision to intervene in the secondary market should offset concerns about the time it will take to deploy the stabilization funds.”

The fact that the bond purchases will be offset by liquidity absorbing operations means they will not have the same potential impact on inflation as straight purchases, such as those undertaken by the U.S. Federal Reserve and the Bank of England.

LIQUIDITY HOSE

In its early-morning statement, the ECB said it would hold its next two three-month liquidity operations at a fixed interest rate, rather than the planned competitive tenders.

It will return to six-month loans, offering banks all the money they ask for on May 12 at a fixed interest rate linked to the main refinancing rate.

Speculation had increased that the ECB would need to take drastic action to stem contagion from Greece’s woes after ECB President Jean-Claude Trichet said after the central bank’s monthly meeting on Thursday that policymakers had not discussed buying government bonds.

European laws prevent the ECB from buying debt directly from governments in the way the U.S. and British central banks have done during the financial crisis, but not on the secondary market.

The ECB announced a 60 billion programme to buy covered bonds last year but this will be its first foray into buying government debt.

Greece’s debt crisis has driven the cost of its sovereign debt and its insurance to record levels. The problems have also started to push up debt costs for other euro zone members with strained public finances such as Portugal, Spain and Ireland.

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