European Central Bank President Mario Draghi was under intense pressure from investors, European leaders and even the United States to deliver on Thursday on his pledge to do whatever it takes to save the euro.
Draghi faced the biggest test of his nine months' leadership of the central bank at its monthly policy meeting, w hich began at 0700 GMT. Any sign that he overplayed his hand when he made the bold pledge a week ago could see markets punish the euro zone.
"Draghi has unfortunately painted himself into a corner," JP Morgan analyst Pavan Wadhwa said in a conference call. "The ECB does need to demonstrate its credibility... Otherwise Draghi will lose face completely."
Reuters reported on Monday that the main idea under consideration is re-activating the ECB's bond-buying programme for Spain and Italy in tandem with the euro zone's rescue funds, but that action could be at least five weeks away.
Highlighting market pressure for the ECB to come up with a plan, Spain had to pay higher yields than a month earlier on its 10-year bonds at an auction on Thursday, although it easily sold 3.1 billion euros of debt, passing a key test.
Spain sold the 10-year paper at an average yield of 6.647 percent - a rate analysts say is close to unsustainable. The rise in Spanish borrowing costs is forcing euro zone policymakers into bolder action than they have taken before.
"We still see risks for the Spanish debt near term as risks of disappointment after today's ECB meeting remain high," said market economist Annalisa Piazza of Newedge Strategy.
Finnish Prime Minister Jyrki Katainen told an Italian newspaper European leaders were preparing for the euro zone's rescue funds to buy bonds on primary market for two years, with a decision likely in September.
German daily Sueddeutsche Zeitung reported the ECB was planning concerted action with the European Stability Mechanism (ESM) to purchase sovereign debt from Spain or Italy - though a final decision was not likely until September.
The ECB has little margin for error to maintain its credibility and avoid bond yields climbing to unsustainable levels in the indebted countries on the euro zone periphery.
WHATEVER IT TAKES
Katainen told Italian newspaper La Stampa: "We will make our proposal in September. So far what has been discussed has been using the ESM to buy bonds of countries in trouble on the secondary market, but I don't think that's the right solution.
"Last year the ECB did that and calmed the markets for a few weeks and then everything went back to how it was before."
He told another Italian newspaper, Repubblica: "We have to find the way to use the (ESM) more efficiently, for example by buying state bonds on the primary market. That would go straight at the problem, lowering spreads more strongly".
Draghi said last Thursday that the political capital invested in the euro is often underestimated.
"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough," Draghi told an investment conference in London.
Spanish and Italian bond yields fell markedly after Draghi's speech, and inaction could send them higher again.
"We could see markets going back to where they were before last Thursday," said Nordea analyst Anders Svendsen, who expects more words but little concrete action from the meeting.
Other countries, especially the United States, have raised pressure on the ECB to act as the two-and-a-half year old euro zone crisis weighs on global growth.
The ECB could be the second major central bank to disappoint in two days after the U.S. Federal Reserve dashed expectations among some investors on Wednesday by taking no immediate new measures to revive the economy.
The Fed stopped short of offering new monetary stimulus, though it signaled more strongly that further bond buying could be in store to help a U.S. economic recovery that it said had lost momentum this year.
The ECB has already bought government bonds through its Securities Markets Programme (SMP), spending more than 210 billion euros on them so far. Re-employing the existing tool would avoid legal battles that any novel measures could face.
While the SMP is widely viewed as having had very limited success, it is at least available immediately and could be used in a new form, combining it with the euro zone's temporary EFSF and permanent ESM bailout funds.
The ECB could use the SMP to buy bonds once Spain makes a formal request for assistance and signs up to a reform programme with international monitoring.
A revival of ECB bond buys was seen as the most likely option in a Reuters poll of money-market traders.
"Based on Draghi's comments a restart of SMP (or EFSF/ESM) buying appears the most likely response," Danske Bank's Allan von Mehren and Anders Moller Lumholtz said in a note.
Another option for a quick start, suggested by Goldman Sachs economist and former senior ECB official Huw Pill, would be for the ECB to let national central banks buy private-sector assets in targeted operations to ease credit availability.
ECB action is hamstrung by EU rules forbidding it from financing governments. The ECB issued a legal opinion in March 2011 ruling out perhaps the biggest gun, giving the ESM bailout fund rights to tap the ECB for funds to increase its firepower.
The ECB has to find a way to get any measures past Germany, the euro zone's largest economy and its principal paymaster. The Bundesbank issues regular reminders of inflationary dangers stemming from non-standard measures such as bond purchases and the limits central banks face.
Former ECB chief economist Juergen Stark, a German who quit last year in opposition to bond-buying, kept up the pressure even as the ECB met, telling N-TV television: "The central bank is not a money printing machine to solve the problems of the real economy and the problems that some countries have."
The dilemma for Europe is that too little action now could create bigger problems later. If borrowing costs don't come down and Spain and Italy are forced to seek bailouts, the ESM's 500 billion euro capacity would soon be exhausted, and it would need more funds.
NO RATE CUT EXPECTED
Another tool at the ECB's disposal - cutting interest rates - is unlikely to be used again so soon after it lowered the main rate to a record low of 0.75 percent in July. A Reuters poll showed that economists expect another rate cut before the end of the year, but only seven out of 70 expected it this month.
News on Thursday of a bigger-than-expected fall in euro zone factory prices in June kept the ECB's options open for a further rate cut later this year.
As the crisis has intensified, the euro has weakened in foreign exchange markets. It has fallen about 15 percent in the past year to trade at $1.23. On a trade-weighed basis it trades at nine-year lows.
The falling euro is good for European exports but is likely to delay the day when inflation falls below the ECB's target of 2 percent. In July, it remained at 2.4 percent. It also assuages fears of deflation, a spectre that could otherwise have prompted the ECB to consider large-scale bond buying.
"To move into large-scale asset purchases from purely monetary stance motivation will take a while," J.P. Morgan economist David Mackie said. "It's certainly not going to happen ... until we get into next year."
(Reporting by Sakari Suoninen; Editing by Will Waterman and Paul Taylor)