By Eva Taylor and John O'Donnell
FRANKFURT (Reuters) - The Ukraine crisis has heightened risks to the euro zone's weak and uneven economic recovery, and a tit-for-tat sanctions war could compound the problem, the European Central Bank said on Thursday as it held borrowing rates at record low levels.
ECB President Mario Draghi cited instability across the Middle East as well as tensions between Russia and Western countries over the conflict in Ukraine among factors weighing on growth in the single currency area. Moscow has retaliated for European Union sanctions by halting imports of food from Europe.
At a news conference after the bank's monthly policy-setting meeting, he stressed the ECB was ready to resort to quantitative easing - printing money to buy securities - if the outlook for inflation fell further. But he brushed off July's 0.4 percent reading, the lowest in more than four years, as a glitch due to temporary energy and food price falls.
"Geopolitical risks are heightened, are higher than they were a few months ago. And some of them, like the situation in Ukraine and Russia will have a greater impact on the euro area than they ... have on other parts of the world," Draghi said.
Having cut interest rates to record lows in June, the euro zone's central bank kept them steady, waiting to see whether schemes such as the ultra-cheap four-year loans to banks it will launch in September will prompt them to lend more.
The decision by the ECB's Governing Council, with representatives from the 18 countries that use the euro, had been expected by economists.
Many are now shifting their attention to next year, when they hope the ECB will follow the United States and other major central banks in launching a quantitative easing program.
Draghi explicitly mentioned that option along with the possibility of buying asset-backed securities (ABS), despite the stated reluctance of Germany's influential Bundesbank.
"I can only reaffirm that the Governing Council is unanimous in its commitment to also use unconventional measures like ABS purchases, like QE, if our medium-term outlook for inflation were to change," the ECB chief said.
The ECB expected strong take-up for next month's flood of cheap money for banks to lend to businesses, he said, adding that real interest rates in the euro zone would remain negative for far longer - up to five years - than in the United States.
While Thursday's news conference did not signal any change in policy, some economists said events could make the ECB act.
"The euro zone is at a crossroads and the economy can go either way," said James Knightley, an economist with ING.
"We are starting to see some signs of stagnation and the geopolitical situation is adding to the risks. Can the weaker euro and better credit conditions offset that? If they don't, that will force the ECB's hand."
Russia has banned imports of fruit and vegetables from the European Union in retaliation for sanctions against Moscow, while NATO warned this week that Moscow could use the pretext of a humanitarian mission to invade eastern Ukraine.
Nonetheless, many economists do not expect a reaction from Frankfurt unless there is a dramatic turn for the worse.
"The geopolitical situation is increasing risks to the economy but we don’t expect them to change course until next year," Societe Generale economist Anatoli Annenkov said.
"We expect the ECB to launch an asset purchase program early next year, buying private-sector rather than government bonds at the outset. But for the time being, they are going a different route to encourage lending."
In June, the ECB became the first major central bank to charge banks for holding their deposits overnight, a step designed to stop them hoarding cash and lend instead.
Apart from Ukraine, the euro zone faces other hurdles.
Data this week showed Italy, the bloc's third-biggest economy, has slipped back into recession while the Bundesbank says even powerhouse Germany stagnated in the second quarter.
Italian Prime Minister Matteo Renzi has led calls to move away from spending austerity to adopting looser EU budget rules, but has been rebuffed by Berlin.
Draghi, an Italian, weighed into the debate by saying that those countries that have carried out the most convincing structural economic reforms were reaping the best rewards in higher growth - an implicit rebuke to Italy and France.
He urged euro zone governments to stick to EU deficit reduction rules and not throw away the gains of fiscal consolidation.
In France, the region's second biggest economy which is also struggling, President Francois Hollande said the ECB and Germany must do more to boost growth and fight a "real deflationary risk" in Europe.
Asked about mounting French calls for a weaker euro to stimulate growth, Draghi listed reasons why conditions were ripe for a fall in the euro's exchange rate, including divergent interest rate prospects with the United States.
Low prices are partly a result of spending cuts and lower wages, reforms the ECB does not want to hinder. But if prices get stuck at low levels, the ECB insists it is ready to act.
(Additional reporting by Paul Carrel in Frankfurt; Writing by Paul Taylor; Editing by Catherine Evans)
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