By Sakari Suoninen
FRANKFURT, Oct 29 (Reuters) - A rise in the euro to atwo-year high is complicating the European Central Bank's policypuzzle, and Governing Council members are at odds over how torespond.
The appreciation is largely about dollar weakness due toU.S. Federal Reserve policy, but the outcome for ECBpolicymakers is concern that already subdued inflation will slowfurther and a nascent economic recovery will falter.
At only 1.1 percent, inflation is running well below theECB's target of just under 2 percent and the currency's risecould depress price pressures even more, making it a live issuefor the euro zone's central bankers.
Three strains of thinking appear to be running through the23-man Governing Council, people familiar with the internaldebate say. One is content to keep open the option of anotherround of long-term loans to banks, another favours an interestrate cut, while a third is prepared to sit this one out.
With markets now expecting the Fed will delay unwinding itsbond-buying stimulus until next year, the euro has strengthenedto its highest level since November 2011 and is up nearly 7percent over the last three months at around $1.38, though thatis way below the peaks above $1.60 it hit in 2008.
In an eBook on forward guidance published last week bypolicy research portal Vox, ECB Executive Board member PeterPraet underlined the ECB's potential to act: "We have not runout of ammunition," he said.
"Further cuts in policy rates remain an option for the ECBif the outlook on price stability so warrants."
The ECB's main interest rate is already at a record low 0.5percent after a cut in May. Then, some policymakers wanted abigger reduction, but in the end the Governing Council agreed tocut rates by 25 basis points.
The euro's buoyancy is not only against the dollar - on atrade-weighted basis it is also at its highestlevel in almost two years. This is starting to affect business.
Several large French companies, including insurer AXA, carmaker Renault and energy management firmSchneider Electric, partly ascribed disappointingresults last week to euro strength.
Lowering interest rates could help by weakening the euro.
TALK BEFORE ACTION
But before any further cut, the ECB is likely to try to talkdown the euro. ECB President Mario Draghi, who took office inNovember 2011, has used the strategy before, with some success.
In February, when the euro was almost as high as it is now,Draghi said the ECB saw its strength as a downside risk toinflation. Partly in response to that, the euro reversed coursewithout the central bank having to take further action.
A rate cut, should there be one, might take months to come.
"The ECB will ramp up its verbal rhetoric at the nextmeeting due to the currency and possibly due to liquiditydevelopments," JP Morgan economist Greg Fuzesi said in a note toinvestors.
The ECB holds its next policy meeting on Nov. 7.
Another way to ease policy would be to offer banks anotherround of long-term loans, known as LTROs, a ploy the ECB used inlate 2011 and early 2012 to funnel more than a trillion euros($1.4 trillion) into the financial system.
One ECB policymaker, speaking under condition of anonymity,said he was not sure an LTRO would be useful as liquidity is nota problem for many banks. Another insider said this option wasmore likely than a rate cut but was not imminent.
Draghi himself keeps mentioning the LTRO as an option, butother policymakers play down the chance of the ECB conductingone in the coming months, if at all, though the ECB is lookinginto the market impact the last round of long-term loans had.
While a persistent rise in the euro will strengthen the casefor ECB action, the puzzle could solve itself should the Fedbegin unwinding its stimulus early next year and the dollarstart to rise. The ECB is watching developments closely.
Draghi said after the ECB's Oct. 2 policy meeting: "Theexchange rate is important for growth and for price stability,and we certainly pay close attention to these developments."
French Industry Minister Arnaud Montebourg renewed his callon Tuesday for the ECB to ease monetary policy and implicitlyblamed German policymakers for preventing it.
Calling for a 10 percent fall in the euro's value againstthe dollar, Montebourg said: "The currency doesn't belong tocentral bankers, the euro doesn't belong to Germany, it belongsto all the members of the euro zone."
However, French Trade Minister Nicole Bricq played down theimportance of the exchange rate in France's economic problems,telling a Reuters Newsmaker Breakfast: "The euro must not be anexcuse for our (loss of) competitive advantage ... We're theones to have to find solutions to our competitiveness handicap."
Price stability is the main focus of central bankers.
The ECB already sees inflation increasing only modestly inthe next two years. Staff projections put it at 1.3 percent nextyear. While the 2015 inflation forecast will be published onlyin December, an ECB policymaker said the central bank seesinflation below 1.5 percent in that year, too.
Euro strength could cut price pressures further to levels atwhich deflation could become a concern.
"This might push inflation to below 1 percent and should setoff alarm bells," OP-Pohjola economist Reijo Heiskanen said."There are some who question whether there is a case for furthereasing with the economy recovering, but with the increasinguncertainty, I see there is one."
JP Morgan calculates a 10 percent currency shock crimps GDPby 1 percent, with most of this felt within two years, and thatthe annual inflation rate is lowered by 0.3 percentage pointsfor two years.
The ECB said in July it expected to keep rates at current orlower levels for an extended period of time, maintaining adownward bias. Despite this 'forward guidance', few investorshave believed that another rate cut could be in the works. Buttheir thinking is changing.
Last time, when analysts expected the ECB to hold rates,Draghi said the Council discussed a rate cut before holdingfire. It will surely do so again.