By Marc Jones and Emelia Sithole-Matarise
LONDON (Reuters) - Last month's dive in euro zone inflation has put a European Central Bank rate cut back on the agenda, but with bank-to-bank lending rates already near zero, markets are struggling to see what difference it might make.
In recent months, further ECB cuts had all but been written off. Troubled economies were showing signs of stabilization, the bank's main borrowing rate was at a record low and its deposit rate, which became more important when it flooded markets with ultra-cheap cash in the crisis, was at zero.
But after a couple of low-ball inflation numbers, the mood is switching towards a possible 25 basis point refi cut to 0.25 percent soon - albeit not this week according to a Reuters poll.
The question is whether a cut would make any difference.
The short answer may be no. The ECB has long complained its low rates are not getting through to euro zone trouble spots where worries about debt levels and lending to and by banks remain high.
For euro traders and for the money market rates that drive the prices of loans to firms and consumers, the greatest significance of a cut may be the signal the ECB sends.
Having been seen as in a neutral gear until last week, the shift back towards easing has changed the mood and caused a spike in FX market volatility.
The euro has dropped over 2 percent against the dollar over the last week as rate cut speculation intensified, but traders reckon it may need hints of more extreme measures for it to move to $1.30. It was at $1.35 on Thursday.
UBS is one of those forecasting a cut on Thursday, but Mansoor Mohi-uddin, head foreign exchange strategy, said options such as negative deposit rates, more long-term cheap loans or even quantitative easing would have a greater impact.
"These are instruments likely to be chosen as policies of last resort. But the risk of the ECB having to eventually consider such tools is set to keep the single currency under this year's highs," he said.
Money market borrowing costs are even less likely to react to a refinancing rate cut.
The huge amounts of cheap money the ECB has pumped into banks during the euro crisis means they already lend at well below 0.25 percent and only the fact that banks can park it with the ECB for free prevents rates falling further.
"It's very difficult to see how a cut in the refi rate is going to significantly alter the shape and values of the market," said Matteo Regesta, a strategist at Citi which expects no cut either on Thursday or in December.
"It doesn't change the outlook of the economy, it doesn't increase the credit channels to the real economy, it doesn't make banks more willing to extend credit to the private sector."
ECB data last week pointed to the first signs of a pick-up in credit conditions but many euro zone watchers believe the euro zone's banks need to be fully repaired before the bloc can kick away from its recent troubles.
The prospect of a rate cut has helped flatten the euro zone money market curve by pushing down the price of borrowing further in the future.
But Jan von Gerich, chief developed markets strategist for Nordea, reckons overnight rates could pop back up slightly if there was no sign the ECB is considering charging banks for parking spare cash by imposing a negative deposit rate.
"If you look at the actual consequences of the rate cut in just refi it is quite marginal. The more important move would be the ECB signaling it really is still in an easing mode and is prepared to do something else," he added.
Government bonds could see a rate cut feed through and bring yields a fraction lower in the two- to five-year sector but the overall impact is likely to be small.
For stock markets, the idea of lower rates almost always supports prices, but European shares <.FTEU3> have struggled to climb back above their recent five-year highs this week.
Many investors have been surprised by the abrupt change in the view of what the ECB might do. Only days before the inflation dive, Ewald Nowotny, one of the bank's longer serving policymakers, said he did not see "a realistic perspective of lowering the main policy rate" or a negative deposit rate.
But with the ECB tasked with keeping inflation just below 2 percent, the reasoning for many economists for their shift in view has been to some degree mechanical.
October's surprise reading of only 0.7 percent combined with the recent slide in oil prices and stronger euro - which both put downward pressure on prices - will have been keyed into the ECB's model and are likely to have set off some warning sirens.
Analysts at JPMorgan think inflation could still be as low as 1.2 percent in 2015 while the European Commission forecasts 1.4 percent in 2015.
If the ECB thinks its staff will come to a similar conclusion when they publish new forecasts next month, it may feel obliged to act.
(Graphics by Vincent Flasseur, additional reporting by Marius Zaharia and Anirban Nag in London, editing by Nigel Stephenson/Jeremy Gaunt)