By Dhara Ranasinghe, Stefano Rebaudo and Naomi Rovnick
LONDON (Reuters) - The European Central Bank has good reasons to hold fire on Thursday after raising interest rates at its past 10 meetings.
Yet conflict in the Middle East, pushing energy prices higher, is another headwind to a central bank that has battled an inflation surge. And traders are keen for a sense of how long borrowing costs will stay high.
"The biggest challenge will be to keep a balancing act -- not sound aggressively hawkish but keep the door open to rate hikes," said ING's global head of macro Carsten Brzeski.
Here are five key questions for markets.
1/ What can we expect this week?
The ECB has signalled a pause and markets price no further rate hikes. It is unlikely to rule out another rise.
ECB chief Christine Lagarde may stick with the high-for-longer mantra that has pushed up long-dated bond yields.
A weakening economy meanwhile suggests the need for further tightening is limited but the ECB is likely to push back against rate-cut speculation.
"It will probably be early next year if they change their mind and think they have to do more," said Francis Yared, global head of rates research at Deutsche Bank. "They pre-committed to let the data speak for a while."
ECB chief economist Philip Lane says the ECB will need time, possibly until next spring, before it can be confident that inflation is coming down.
2/ Will the ECB discuss quantitative tightening?
The ECB is not expected to start active bond sales soon. Instead, debate centres on whether to bring forward the December 2024 end-date for reinvestments from the Pandemic Emergency Purchase Programme (PEPP), which many favour.
Rising Italian bond yields could cool talk of a quick end.
Under PEPP, reinvestments can be skewed to countries most in need. Lagarde has said this is the first line of defence against fragmentation, excessive yield spread widening that reduces the effectiveness of monetary policy.
"We won't have a decision on PEPP reinvestments after the recent rise in (Italian) yields," said UBS chief economist Reinhard Cluse. "The market still has a degree of nervousness...The ECB doesn't want to pour oil into the fire."
A decision may come in December or early 2024, he added.
3/ What does a fresh rise in energy prices mean?
European gas prices are up 35% so far this month, oil is above $93, threatening to push inflation back up.
As an energy importing region, Europe is more vulnerable than the United States to an inflation spike caused by Middle East tensions, said Chris Jeffrey, head of rates and inflation at Legal & General Investment Management.
He added that, for now, Lagarde would be keen not to get "dragged into" discussing energy prices until it becomes clearer if the run-up will be sustained.
UBS' Cluse said energy prices were not "a game changer in the inflation outlook" because strong disinflationary base effects were in force.
The ECB expects headline inflation to ease to 3.2% in 2024 from an average of 5.6% in 2023.
4/ What does the ECB do if things go wrong with Italy?
Not much for now.
Higher deficit forecasts have pushed up Italian borrowing costs, widening the gap over Germany to 200 basis points -- prompting some speculation that the ECB may have to jump in and calm markets.
The Transmission Protection Instrument, a bond purchase scheme to help more indebted states and prevent fragmentation, joined the toolkit last year.
Five out of six sources told Reuters recently there was no rush to intervene.
"They will try and stay on the sidelines for as long as possible," said ING's Brzeski.
5/ What about tighter financing conditions?
Wednesday's September bank lending data should offer some clues.
The amount of money circulating in the euro zone shrank by the most on record in August as banks curbed lending and depositors locked up savings.
The ECB will likely scrutinise that and other signs of tightening in financing conditions. Surging U.S. Treasury yields have dragged up European borrowing costs, supporting the case for no further hikes.
(Reporting by Dhara Ranasinghe, Stefano Rebaudo and Naomi Rovnick; Editing by Susan Fenton)