ECB's Panetta warns of risk of damage to economy from high rates

By Giuseppe Fonte

ROME (Reuters) -The European Central Bank (ECB) must not cause "unnecessary damage" to the economy and financial stability through sustained high interest rates, new Bank of Italy governor Fabio Panetta said on Thursday.

Panetta, a member of the ECB's governing council, added that the round of monetary tightening which saw a streak of 10 straight rate rises until September, has not yet had its full impact and would continue to dampen demand in the future.

In his first major speech since becoming head of the Italian central bank, Panetta warned that the euro zone economy would remain weak in the last three months of this year and that risks for the economy were tilted to the downside.

"We need to avoid unnecessary damage to economic activity and risks to financial stability, which would ultimately jeopardise price stability," Panetta said, speaking about interest rate policy.

Before taking over at the Bank of Italy this month, Panetta sat for almost four years on the ECB's Frankfurt-based board, where he was considered an interest rate dove.

The current level of rates is consistent with bringing inflation down to the ECB's 2% target, he said in Thursday's speech.

The ECB has lifted its key deposit rate to a record high 4% this year to curb price growth but has signalled steady policy for the next few quarters. Markets have started to position for the first rate cut, with a move seen as soon as April or June.

INFLATION DECLINES

Euro zone inflation tumbled more than expected this month, according to figures on Thursday that are likely to fuel bets on early spring rate cuts in defiance of the bank's explicit guidance.

Panetta called the data "a favourable development".

He indicated that a rapid decline in inflation could allow the ECB to curtail the current phase of relatively high rates.

"Monetary conditions need to remain tight for as long as necessary to consolidate disinflation," he said in his speech.

"The duration of this phase will depend on development in macroeconomic variables; it could be short if continued weakness in economic activity accelerates the decline in inflation," he added.

He noted that the ECB's monetary tightening had been tougher than usual because as well as raising interest rates it had also reduced its balance sheet, which crimps liquidity and contributes to a "contractionary effect on the economy."

Turning to Italy, he said the debt-to-GDP ratio, currently around 140%, needed to be reduced.

"Debt has been a weight on the Italian economy's shoulders for too many years," he said.

(Reporting by Giuseppe Fonte and Gavin Jones, writing by Keith Weir, editing by Christina Fincher)