* Bonello says ECB still has room to cut rates
* Needs to think carefully about deposit rate situation
* Narrowing rate corridor threat to money mkt improvements
* Deflation not currently seen as a risk
By Marc Jones
VALLETTA, March 13 (Reuters) - The European Central Bank still has some room to cut interest rates but is running out of rope, Governing Council member Michael Bonello told Reuters.
The ECB cut its benchmark rate to a record low 1.5 percent last week in the battle against the global financial crisis. It has signalled it is prepared to go lower still although policymakers appear to differ on how far, and how quickly.
In his first interview of 2009, Bonello told Reuters that further interest cuts were justified. "There is some room for rate cuts, but of course the scope for that has been reduced by the March cut," he said.
"The risks to price stability are now more balanced, inflation expectations are well anchored and we must remember that policy rates are at a record low level, and market rates too are beginning to reflect the drop in policy rates."
The comments are in synch with analyst expectations that the bank will cut rates again in April. [ECB/INT]
At the same time Bonello issued a note of caution, questioning whether rate cuts were packing their usual punch.
"Although there have been some improvements in the transmission mechanism, recent cuts have not been transmitted in full ... As long as these circumstances prevail, policy rate cuts will have a limited impact I think," he said.
Bonello also joined ECB colleagues such as President Jean-Claude Trichet, board members Juergen Stark and Jose Manuel Gonzalez-Paramo, and Bundesbank chief Axel Weber in talking about the problems of cutting rates to zero.
"Very low interest rates can also have negative effects," he said. "They can delay balance sheet corrections and that is necessary if we are to have a sustained recovery and the credit channel working properly."
But he also raised concerns about defining a lower limit for interest rates, as Weber has done recently, drawing a line in the sand at 1 percent. [ID:nLP640322]
"You can't be very precise from a distance beforehand of what might be necessary," Bonello said. "I would rather be guided by the evidence at the time of the decision needs to be taken, rather than have any one number in mind."
Overall he struck a pragmatic tone, saying the bank should not rule anything out in case of a worst case scenario and also not being too hasty in cutting rates.
"If you cut interest rates when there is no very clear threat to price stability, then you could have consumers and investors revising their own expectations of inflation to the point that they enter negative territory, and then there would be a danger of sparking off a self-perpetuating mechanism," he said.
"Our latest reading of the tea leaves suggests that we could witness the beginning of a gradual recovery in the first half of next year," he said.
DEFLATION
Bonello, who is also head of Malta's central bank, played down the threat of deflation.
"Inflation expectations ... are well anchored at our level
of price stability. So for the moment we don't see any danger of
the that kind of (deflation) spiral developing, but of course
one continues to monitor the situation."
"Of course we will have a string of negative inflation numbers this year but that will largely reflect base affects related to commodity prices," he said.
He also mirrored recent comments from ECB board member Lorenzo Bini Smaghi in warning against a yo-yo approach to rate moves. "You can only take interest rates all the way down if there is an assurance that rates will remain at that very low level for a reasonable period of time," he said.
"Otherwise prospective lenders, people who normally buy longer-term securities, will be discouraged from doing so."
DEPOSIT RATE
Financial markets have traditionally focused on the ECB's benchmark interest rate, now at a record low of 1.5 percent after the latest 50 basis point cut in March [ID:nECBRATES].
But the majority of economists say the bank's decision to flood money markets with billions of extra euros means the rate at which it accepts overnight deposits -- 100 basis points below the main rate -- is the driver of all-important money markets.
Bonello acknowledged the bank's 'deposit rate' was an increasingly important part of the ECB's monetary arsenal.
He also warned against narrowing the gap between the deposit rate and the bank's main rate again to 50 basis points from 100 basis points, as the ECB tried late last year, saying it risked ruining recent improvements in money markets.
Weber said on Tuesday he would prefer the deposit rate to remain at 0.5 percent, even with the main refi rate at 1 percent.
"You risk creating an incentive for banks to start hoarding liquidity again," Bonello said.
"If there is a chance this beginning of an improvement in the interbank market could develop further, so one has to be fully aware that by reversing this decision on the corridor you might be losing some of that advantage that you have gained."
For story on Bonello's views on use of additional non-standard measures by the ECB please click [ID:nLAG003299]
For highlights of comments from interview with Bonello please click on [ID:nLD400281] (Reporting by Marc Jones, editing by Mike Peacock)