* Indexing 3-month loans keeps markets guessing on rates
* Suggests continuing bank support no barrier to rate hikes
* Twin approach would not alter rate rise impact
By Marc Jones
FRANKFURT, Sept 22 (Reuters) - The European Central Bank's decision to put a tracker rate on its three-month loans will keep markets on alert and suggests it is prepared to hike rates while keeping support for vulnerable banks in place if needed.
If economic recovery starts to threaten the ECB's core goal of keeping prices in check, it may find itself needing to raise rates whilst still pumping cash to what Austria's Ewald Nowotny calls "addicted banks" that can't be weaned off its emergency funding.
Central bankers are now putting the onus on governments to deal with problem banks.
Meanwhile, analysts say the ECB's move to "index" the cost of three-month loans to its benchmark interest rate gives it more room to manoeuvre around these banks.
And while Nowotny and Germany's Axel Weber have said they expect the ECB's exit to involve first withdrawing liquidity and then raising rates, ECB President Jean-Claude Trichet -- who says he is the only spokesman for the ECB -- has been careful not to commit.
On Sept 2, Trichet again stressed that the ECB could "make decisions on the standard measures without having the phasing out of all the non-standard measures", code for raising rates while keeping full allotment in place.
Deutsche Bank economist Gilles Moec thinks indexing loans removes the implicit promise not to raise rates for a set period and suggests continued liquidity support is no barrier to rate hikes should inflation threaten.
The ECB extended its offer of unlimited liquidity into early 2011 this month, but only the one-month and one-week operations are fixed at 1 percent with the three-month operations using an indexed or tracker rate to the main refi rate.
"It is a reminder that liquidity provision and monetary policy are two different things," Moec said. "The ECB's monetary policy is driven by the euro zone average while its liquidity provision is governed by the most fragile parts.
"If there is any sign there is lingering stress they (ECB) could hike rates while maintaining full allotment in the main refinancing operations."
ADDICTION PROBLEM
The decision to index lending should also head off heavy bidding at the last currently scheduled all-you-can-borrow three-month operation in December -- and in future, assuming the policy is continued next year.
Speculative bidding -- where banks borrow heavily hoping to lock in cheap money ahead of a rate hike -- would swamp money markets and render any rate hike temporarily ineffective.
"The underlying message it sends is that you are continuing to exit and you are totally ruling out any speculative bidding come December," said one European money market desk head.
"It seems crazy to talk about rate hikes now, but by the time we get there who knows what the situation will be, especially if the stronger-than-expected recovery continues."
Even so, economists say the ECB could still be lending banks unlimited one-week and one-month funds at the end of 2011, when most analysts polled by Reuters expect a rate rise.
"The banking and sovereign debt stresses are very much linked," said JP Morgan economist David Mackie. "It could take us a another year to stop worrying about the sovereign stress, so it's certainly possible that the ECB will still be doing this at the end of next year."
Greek banks took 96 billion euros of ECB funding in August compared to less than 4 billion in July 2007 before the financial crisis hit, and banks in Ireland and Portugal are borrowing similarly high amounts.
Central bank insiders say Italy's Mario Draghi recently urged a serious ECB debate about how to manage the exit while so many banks rely on its funds.
HANDS OFF HIKE
Other ECB members appear to share Trichet's pragmatic view of support measures.
"The moment we start our unwinding process, we will take all relevant elements into account. So if, at that very moment, we would be afraid of a negative impact on the economy, we would most certainly reconsider our plans," Holland's Nout Wellink said in an interview published on Tuesday.
It would be complicated for the ECB to explain any decision to hike rates while still pumping out unlimited cash.
But the two-pronged approach, while messy, could work. If unlimited cash was available only in one-week rather than three-month portions by then, the ECB would still get the normal impact from a rate hike.
"If you wanted to continue providing unlimited liquidity while raising interest rates, the system in Europe would in many ways facilitate that quite easily," said Societe Generale economist James Nixon.
"The impact of a 25 basis point hike would be exactly the same. It would just mean that overnight rates, instead of being centred around the ECB's main refinancing rate, would sit at a small margin to the deposit rate." The ECB's deposit rate is currently 0.25 percent, while the benchmark is 1 percent.
That could all change, though, if the health of vulnerable banks suddenly improved. Excess cash in the system would soon disappear as banks sucked it up, driving market rates the 75 basis points towards the refinancing rate.
Such a move, although likely to take time, would be bigger than any single interest rate hike in the ECB's history, and all without the ECB's finger going near the interest rate trigger.
(Editing by Ruth Pitchford)