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Frankfurt - Financial markets were in a high state of alert on Thursday, awaiting a European Central Bank meeting expected by many to signal action to tame the eurozone debt crisis now threatening Spain.
Economists said many in the markets think the ECB could now maintain or even boost cheap funding for banks rather than continue winding down in a key stimulus measure, as it expected to do earlier.
Rumours said "the ECB will announce some big and bold moves on its government bond purchase programme," UniCredit fixed income strategist Luca Cazzulani said.
But he and others did not expect the traditionally cautious central bank to roil an already tense situation further.
A growing belief that the ECB will signal more help for banks, rather than the beginning of a winding down, were a key factor in an easing of market pressure on Spain on Wednesday.
This was because it would mean a reduction of risk for investors who have been alarmed by a decision by eurozone finance ministers to increase their risks.
"We expect no 'shock and awe' announcement" on additional purchases of eurozone sovereign bonds, Cazzulani said.
While the ECB's main interest rate was expected to remain at a record low of 1.0%, president Jean-Claude Trichet could suggest that the bank would make more bond purchases through its Securities Markets Programme, he noted.
"A lot of investors have progressively turned their attention over the past few days to the ECB as the potential actor that could put the fire out," the bond strategist said.
Under a controversial programme that has divided the bank's governing council, the ECB has bought nearly €70bn worth of government bonds since May, a modest sum compared to moves by the US Federal Reserve and the Bank of England.
Some in the markets have speculated that the ECB could now pull out the stops to keep a festering debt crisis from spreading to major economies like Italy and Spain.
'No nuclear announcement'
Such a move would present ECB policymakers with a major dilemma however, Cazzulani said.
"The problem with buying large amounts of debt is that it would become very difficult to sterilise them," he said, as the ECB currently does by taking an equivalent sum in short-term deposits from commercial banks as an offset.
"If they don't sterilise it it will be politically unacceptable for some EU countries" which fear inflation could take hold in the 16-nation eurozone.
Buying government debt without offsetting the operations amounts to creating money and as the money supply increases so does the risk of inflation, which would raise hackles in eurozone heavyweight Germany.
The ECB is mandated moreover to keep eurozone inflation below but close to two percent, essentially the level it stood at in November.
If inflation were to begin to rise, the ECB would have to tighten monetary policy, which could choke weaker economies struggling to grow so they can cut public deficits and reduce debt.
The central bank could announce more unlimited three-month loans in January, an exceptional measure it had previously been expected to discontinue, economists said.
But Goldman Sachs' Natacha Valla agreed with those who felt "no 'nuclear' announcement" was likely to come out of the governing council meeting.
At Morgan Stanley, economists said: "In the ECB's view, the next step-change towards a solution to the sovereign debt crisis has to come from governments. We agree."
Cazzulani did not expect the ECB to say how much it would spend on bond purchases which the bank says are needed to keep markets running smoothly.
But he noted the total eurozone governement bond market is worth around €5.5 trillion and that it would take about €1 trillion to buy "a relevant share of Spanish and Italian debt."
Meanwhile, the ECB is also to present new staff forecasts for growth and inflation on Thursday. In September it estimated 2010 growth at 1.6%, followed by 1.4% next year.
Inflation was tipped to come in at 1.6% this year before edging up to 1.7% in 2011.
