(Adds detail on Bundesbank collateral, TARGET2 positions)
By Eva Kuehnen
FRANKFURT, March 1 (Reuters) - Some European Central Bank policymakers are alarmed that a dramatic loosening of lending policy stemming from a 1-trillion-euro wave of cash unleashed into the financial system will fuel imbalances in the euro zone and stoke inflationary pressures.
Led by Bundesbank chief Jens Weidmann, who was previously a top advisor to German Chancellor Angela Merkel, they are pushing for the central bank to think about an exit strategy after it fed banks 530 billion euros on Wednesday in the second of two cheap, ultra-long funding operations.
The signs of internal division add weight to what sources have already told Reuters: that the central bank does not intend to offer any more cheap three-year cash. The chances of interest rates dropping below their record low one percent also appear to be diminishing.
The huge take-up at Wednesday’s so-called LTRO meant that in the space of two months the ECB has injected over a trillion euros into the financial system.
While the twin operations have banished the threat of a credit crunch, the ECB hawks are worried that the ploy risks fostering banks forever dependent on external support, fuelling imbalances between strong and weak euro zone members and priming an inflationary timebomb for the future.
Weidmann wrote to ECB President Mario Draghi last month to express concerns about risks stemming from a decision the ECB took in December to ease rules on the collateral banks must put up to tap its funding operations, a central bank source said.
That decision, which Weidmann opposed and now wants reversed, resulted in some 800 banks partaking in the ECB’s second offer of one percent money on Wednesday - a marked increase from the 523 bidders at the first LTRO in December.
“This shows that there are diverging views on all of this in the ECB Governing Council and it is not likely go away until the sovereigns come up with some big measures, which looks rather unlikely,” said Citigroup economist Juergen Michels.
Draghi asked Weidmann to put his views on paper after they discussed the issue of growing imbalances in the euro zone’s cross-border payment system TARGET2, which have essentially seen central banks in weaker economies build up liabilities which could fall on the stronger ones.
The Bundesbank chief believes those risks could be exacerbated by the looser collateral rules, the source said. The issue is also being debated more widely in the ECB’s 23-man Governing Council.
Draghi can ill afford to ignore the ECB hawks’ concerns.
Last year, two German heavyweights on the Governing Council quit in protest at the ECB’s controversial programme to buy sovereign bonds - a measure they felt came too close to financing governments. Weidmann too opposes this option.
Some within the ECB have also lost on some key policy decisions last December - a cut in interest rates to a record low of 1 percent, and the loosening of the collateral rules.
The Bundesbank also pushed for a higher interest rate on the 3-year LTROs, but failed to convince other Council members.
Draghi only assumed the ECB presidency after Weidmann’s predecessor, Axel Weber, quit early last year, clearing the way for the Italian to take the helm of the euro zone’s most powerful institution despite the concerns of many in Germany.
The Italian risks a deep and damaging split on the Council if he tests the hawks too far, weakening the ECB just a few months into his eight-year presidency.
But it may be that after such a dramatic start in policy terms he too is content to take a back seat now. Certainly, in public Draghi has consistently put the onus on euro zone governments to take the lead.
The ECB looks set to leave interest rates on hold at 1.0 percent far into 2013, according to the consensus of more than 70 economists polled by Reuters, who until three weeks ago forecast a rate cut later this year.
Draghi is already at odds with some powerful voices in Germany, taking a nonchalant view last month about the TARGET2 imbalances.
The Bundesbank considers the TARGET2 imbalances a symptom of underlying problems in the currency bloc and is watching them with increasing concern as they reflect a stronger reliance of banks in weaker euro zone countries on cheap ECB funding and growing risks on those countries’ central banks balance sheets.
If the euro zone breaks up - which few expect - the larger national central banks in the 17-country bloc would be left with a greater share of the potential losses, as they contribute a greater share of the ECB capital.
Hans-Werner Sinn, president of Germany’s influential Ifo think-tank, has argued that stronger countries such are financing the deficit extravaganzas of Greece, Portugal and Ireland via the euro zone cross-border payment system.
Draghi played down these concerns last month, telling the ECB’s monthly news conference: “We, the Governing Council, thought that the amount of risk that was taken on board was perfectly acceptable and very well managed.”
The Bundesbank wants to assess the idea of peripheral euro zone central banks providing collateral to those in the bloc’s core as a back-up for the TARGET2 imbalances - an idea they are unlikely to buy.
THAT‘S ALL FOLKS
Weidmann believes the Bundesbank’s credibility depends on the trust of the German people - generally a risk-averse bunch on financial matters - which he feels duty-bound to uphold.
Against this backdrop, it is perhaps no coincidence that details of his letter to Draghi emerged in the Frankfurter Allgemeine Zeitung (FAZ) - a respected German daily.
In his letter, Weidmann called for a return to collateral rules as they had been before the crisis, the FAZ said.
Weidmann had already expressed concern that “too generous” supply of liquidity could create risky incentives for banks, which could in turn store up future inflation risks.
Ewald Nowotny, a member of the ECB’s 23-man Governing Council, went further on Tuesday and said the bank should think about an exit strategy after its massive cash injections.
Their case may be supported by a pick-up in euro zone inflation in February to 2.7 percent from 2.6 in January, well above the ECB’s target of just below 2 percent.
Central bank sources have already told Reuters the ECB wants Wednesday’s second LTRO to be its last, putting the onus back on governments to secure the euro zone’s longer-term future.
In the United States, the Federal Reserve is also taking a cautious view on further policy impetus. Fed Chairman Ben Bernanke on Wednesday dashed the hopes of some investors who were betting on more U.S. monetary stimulus.
The ECB hawks’ bargaining position could be further bolstered if Luxembourg’s central bank chief, Yves Mersch, takes over from Spain’s Jose Manuel Gonzalez-Paramo on the ECB Executive Board from June 1.
Mersch, who has one of the strictest anti-inflation stances among ECB policymakers, is seen as the frontrunner for the post, which manages the ECB’s day-to-day business. (Writing by Paul Carrel, editing by Mike Peacock)