By Dhara Ranasinghe, Stefano Rebaudo and Vincent Flasseur
LONDON (Reuters) - The European Central Bank is set to deliver its first interest-rate hike since 2011 this week, yet markets are already fast-forwarding to focus on the path for higher rates beyond Thursday as economic prospects darken.
That outlook is getting murkier by the day because inflation is still accelerating and growth slowing sharply.
"The trade off the ECB is facing is more severe than any of the other major central banks," said Silvia Ardagna, head of European economics research at Barclays (LON:BARC).
Here are five key questions for markets.
1. So, we'll get modest a rate hike this week?
Most likely. The ECB will almost certainly hike and it has already flagged a 25 basis point (bps) rate rise to contain inflation running at a record high 8.6%. It last raised rates in 2011. Its -0.5% deposit rate has been negative since 2014.
A bigger 50 bps move is not ruled out, especially given euro weakness, but some analysts say it is unlikely given growth worries.
"More than 25 bps would, in the current situation, be seen by markets as a very hawkish signal," said Martin Wolburg, senior economist at Generali (BIT:GASI) Investments.
(Graphic: ECB monetary policy, https://graphics.reuters.com/EUROZONE-MARKETS/ECB/zdpxobnwrvx/chart.png)
2. What is the ECB's plan to contain bond market strain?
The ECB is set to announce a new anti-fragmentation tool in response to a surge in bond yields that has hit the most indebted countries hardest.
Policymakers are weighing up whether they should announce the size and duration of a new bond-buying scheme, sources recently told Reuters.
Announcing a large envelope could boost confidence in the ECB's commitment to fight so-called fragmentation risks, but investor disappointment could follow if the size is too small. In the meantime, a fresh political crisis in Italy is putting more upward pressure on Italian borrowing costs.
"The stronger they devise their instrument, the smaller the risk of it being tested by markets," said UBS chief European economist Reinhard Cluse.
(Graphic: Italian bond yield spread, https://graphics.reuters.com/EUROZONE-MARKETS/ECB/lgvdwzngepo/chart.png)
3. What does a weakening growth outlook mean for rate hikes?
Investors will want to know whether a larger ECB rate hike in September - flagged last month as a possibility - is still on the cards, especially as the growth outlook has deteriorated in recent weeks on growing fears about gas supplies to Europe.
Money markets have started to dial back expectations for the scale of ECB monetary tightening, and analysts say the ECB's window of opportunity to hike could close sooner than hoped.
"A weaker economic outlook will affect the ECB tightening path," said Generali Investments' Wolburg, whose base case for the deposit rate is 1.25% by end-2023.
(Graphic: Inflation at record highs but market expectations ebb Inflation at record highs but market expectations ebb, https://graphics.reuters.com/EUROZONE-MARKETS/ECB/lgpdwzndqvo/chart.png)
4. Does the ECB expect a recession?
The ECB's next set of economic forecasts are out in September, but no doubt its chief Christine Lagarde will be asked about her views on the outlook.
Thursday's meeting coincides with the end date for annual maintenance on the biggest single pipeline carrying Russian gas to Germany. Fears about Russia cutting off gas supplies to Europe have heightened recession fears.
The European Commission now expects the euro zone economy to grow 1.4% next year versus 2.3% previously.
"They (the ECB) will recognize that a recession is a reasonable risk case, but it's not their base case at this point," said Andrew Mulliner, head of Global Aggregate Strategies at Janus Henderson.
(Graphic: Euro zone economic worries are growing Euro zone economic worries are growing, https://graphics.reuters.com/EUROZONE-MARKETS/ECB/akpezwmwxvr/chart.png)
5. Is the ECB worried about the weak euro?
The euro's fall to parity against the dollar for the first time in two decades poses a problem for the ECB. Letting the currency fall exacerbates inflation, already well above its 2% target. A more hawkish stance to shore up the currency, or more rapid rate hikes, could hit growth.
But moves to boost the euro are seen as unlikely.
"They know that getting caught in that loop of trying to support your currency through central bank actions is pretty dangerous as you need to tighten too much, hurting the economy and the currency," said Janus Henderson's Mulliner.
(Graphic: To parity and beyond To parity and beyond, https://graphics.reuters.com/GLOBAL-FOREX/gkplgymaavb/chart.png)