By Leika Kihara
FRANKFURT (Reuters) - The European Central Bank is expected to hold off on cutting interest rates on Thursday, opting instead to loosen lending conditions to fight off the danger of debilitating low inflation.
A slight upward surprise in euro zone inflation in February and initial signs of life in some economies in the region have eased pressure on the ECB to take radical steps.
Quantitative easing - actually buying assets to drive money into the system as the U.S. Federal Reserve and others have done - is politically far too difficult.
Imposing negative deposit rates, essentially charging bank depositors, is also controversial within the euro zone bloc and might not be effective.
But with inflation running in the ECB's "danger zone" below 1 percent - 0.8 percent at last count - the bank is poised to open some money spigots by ending operations to drain funds from the financial system.
The ECB currently "sterilizes" money it puts into the system though bond purchases by withdrawing other money to offset the effect. Stopping this would mean more money available for lending.
The step is easier to swallow for the Bundesbank, Germany's conservative central bank, and meets market expectations for some action by the ECB signaling its resolve to maintain its accommodative policy stance for an extended period of time.
"This could be the compromise solution," said Nick Matthews, economist at Nomura.
"It helps those (at the ECB) who are still unsure about a negative deposit rate and don't see that there is room to cut the refinancing rate on its own anymore. So this would be seen as the ECB doing something."
The International Monetary Fund, however, believes the ECB needs to do much more.
Reza Moghadam, the head of the IMF's European Department said in a blog on Wednesday that the ECB should cut interest rates and pump out more money, perhaps through quantitative easing.
Nonetheless, ending sterilization is the prime option for ECB policymakers at Thursday's meeting.
An ECB source predicted there would be unanimous agreement to end it for bond purchases under the bank's Securities Markets Program (SMP).
Separately, Draghi's predecessor as ECB president, Jean-Claude Trichet, told reporters in Abu Dhabi that ending sterilization is "something which is certainly possible taking into account the present situation."
The Governing Council will, for the first time, publish staff forecasts stretching into 2016 when it meets. Draghi described this as "a very significant change in our analysis" after the bank's February 6 policy meeting.
Draghi has set out two scenarios that could trigger fresh action: a deterioration in the medium-term inflation outlook and an "unwarranted" tightening of short-term money markets.
Many analysts predict ending sterilization is only the start of the ECB's long battle to fight off deflation risks, with a growing minority of economists polled by Reuters last week saying the bank may be forced to print money this year.
Despite insisting that the euro zone is not experiencing deflation, Draghi warned on Monday that inflation is "way below" the bank's goal and if it stays so for too long, it will be harder to get it back up to the target.
Looming in the minds of policymakers are fears of a Japan-style deflation, which became so entrenched companies and households held off on spending on expectations of lower prices ahead, leading to two decades of economic stagnation.
Like the Bank of Japan, which meets to set policy next week, the ECB is running out of room to cut interest rates. Its main refinancing rate is at 0.25 percent and the deposit rate it pays banks for holding their money overnight stands at zero, raising a question over how potent a small rate cut would be.
Ending the SMP sterilization operations would lack the "wow" factor of such quantitative easing but would show the ECB is being proactive and delivering on its pledge to keep an accommodative policy stance and take fresh action if needed.
(Additional reporting by Paul Carrel in Frankfurt and Martin Dokoupil in Abu Dhabi Editing by Jeremy Gaunt)