Slow euro zone lending may keep ECB on hold

The illuminated euro sign is seen in front of the headquarters of the European Central Bank (ECB) in Frankfurt April 5, 2011.

FRANKFURT (Reuters) - Lending to euro zone firms was slower than expected in July European Central Bank data showed on Friday, putting more pressure on the bank to keep interest rates on hold and tone down its view on inflation dangers.

Growth in loans to the euro zone private sector slowed to an annual rate of 2.4 percent, weaker than analysts' expectations for 2.5 percent growth and down from June's level. Month-on-month lending fell for the second time in four months, dropping 3 billion euros to 4.734 trillion euros.

Analysts said the data adds to signs the euro zone economy is deteriorating sharply and increases the pressure on the ECB to abandon any hopes it still harbours of lifting its key interest rate further from the current 1.5 percent.

"Today's money supply and credit growth data will reinforce pressure on the ECB to change its assessment of inflation risks next month. Inflation risks are clearly no longer skewed to the upside," said ING economist Martin Van Vliet.

"The apparent slowing in already-sluggish credit growth highlights the fragility of domestic demand and ties in with the sharp slowdown that has gripped the euro zone economy."

Growth in lending to house buyers, often seen by economists as a leading indicator of lending trends, eased to 3.9 percent on the year from 4.3 percent in June. Total lending growth to households also slowed, dropping to 3.2 percent from 4.3 percent the previous month.

Overall the data pointed to an absence of significant inflation pressures in the 17-nation region. At 2.1 percent, the three-month moving average of M3 growth remains well below the ECB's reference rate of 4.5 percent, above which the bank sees dangers to medium-term price stability.

M3 money supply, a measure of cash readily available to spend that the ECB sees as a leading indicator for inflation, grew 2.0 percent on an annual basis in July, down from 2.2 percent growth in June. Broader M1, also seen as a leading indicator of the economic cycle by the ECB, decelerated to 0.9 percent.

RATE DEBATE

The figures fit with the recent trend of poor data. German business morale posted its steepest drop since the collapse of Lehman this month, while other key data such as PMI's have indicated the recent economic recovery is grinding to a halt.

The deterioration has seen financial markets start to price in the possibility the ECB may have to cut interest rates early next year, a stark contrast to just a few months ago when a steady series of rate hikes were seen as a virtual certainty.

The data show "there is still no indication that the ECB rate increases we have had were justified and they are starting to argue that the ECB should be lowering rates here," said Barclays economist Julian Callow.

But Citi's Juergen Michels said there was still a long way to go to convince the ECB to cut rates, having raised them by 25 basis points twice this year.

"I think the ECB will keep interest rates on hold. There is a pretty big hurdle for cutting interest rates. They are clearly in negative territory and inflation is above target," he said.

(Reporting by Marc Jones; Editing by Susan Fenton)