By Eva Kuehnen
FRANKFURT (Reuters) - The European Central Bank will monitor the economic impact of a strengthening euro, ECB President Mario Draghi said on Thursday, feeding expectations the climbing currency could open the door to an interest rate cut.
After the ECB left its main interest rate at 0.75 percent on Thursday, Draghi said the exchange rate was near to its long-term average but went further than many analysts had expected.
"The appreciation is, in a sense, a sign of return of confidence in the euro," Draghi told a news conference.
"The exchange rate is not a policy target, but it is important for growth and price stability and we certainly want to see whether the appreciation is sustained and will alter our risk assessment as far as price stability is concerned."
The euro hit a 15-month peak of $1.3711 on February 1. It traded below that level on Thursday and fell to a one-week low against the dollar and sank against the yen after Draghi's comments.
French President Francois Hollande said on Tuesday the euro zone must develop an exchange rate policy to protect the currency from "irrational movements". Germany has been cooler to any thoughts of exchange rate action.
By linking the euro's exchange rate to growth and price stability, Draghi achieved a deft piece of verbal intervention, analysts said.
"This hints that euro strength -- if sustained -- could eventually trigger a rate cut," said Nick Kounis at ABN Amro.
Carsten Brezeski at ING added: "Draghi successfully tried to talk down the euro exchange rate and opened the door for possible policy action."
Last month, Draghi unwound earlier expectations of a rate cut by citing a batch of improving economic indicators. But since then the euro has appreciated further.
The ECB's room for manoeuvre is limited, however. Even if it wanted to, the bank's statutes mean it is ill-equipped to join a currency "race to the bottom".
Furthermore, the world's other top central banks are expanding their balance sheets by printing money, or at least not reversing course, while the ECB's balance sheet is tightening, partly due to banks paying back early cheap money the central bank doled out last year.
A by-product of that could be to drive the euro yet higher.
IRISH DEBT DEAL
Although it took no monetary policy action, the ECB and Ireland reached a compromise on a long-standing dispute over the cost of servicing money borrowed for a failed bank.
Dublin rushed through emergency legislation early on Thursday to liquidate failed Anglo Irish Bank as part of a compromise to avoid paying 3.1 billion euros a year until 2023 on money it took for the stricken lender during a meltdown of the main Irish banks in 2008.
Draghi merely said the ECB "took note of the Irish operation" but Irish premier Enda Kenny stood up in parliament and declared the deal done that could go a long way to allowing Ireland to quit its bailout program this year.
Draghi gave a similar view on the state of the euro zone economy to the one he gave in January. Economic weakness was "expected to prevail in the early part of 2013" but later in the year, activity should gradually recover.
He said the recent move by banks to pay back early about 140 billion euros of cheap three-year money the ECB gave them last year was a positive sign.
"This reflects the improvement in financial market confidence," Draghi said, adding that the ECB would watch to see if the money market tightened conditions by stealth.
"We will closely monitor conditions in the money market and their potential impact on the stance of monetary policy, which will remain accommodative," he said.
A Reuters poll of economists last week suggested official rates would not change until at least July 2014.
Draghi was pressed about what he knew of the derivatives scandal at Siena's Monte dei Paschi bank, and what he did about it when he headed Italy's central bank from 2006 to 2011.
Italy's third largest and oldest bank has been at the centre of a financial and political storm, facing losses of about 1 billion euros from a series of derivatives and structured finance trades and after a 9-billion-euro acquisition of smaller rival Antonveneta which left it badly weakened.
Draghi said there was no implications for the ECB's future role as a European bank regulator.
"The IMF has publicly stated that their preliminary view is that the Bank of Italy took timely and appropriate action within the limits of legal framework to address problems at (Monte dei Paschi)," he said. "Oversight was close and supervisory action escalated appropriately as (the bank's) problems became acute."
A senior Italian central bank source told Reuters this week that Draghi was informed of doubts raised by Bank of Italy inspectors but had little control over what has been widely criticized as ineffective oversight of the stricken lender.
He has already faced criticism with former Italian economy minister Giulio Tremonti said it was "stupefying" that in his role as supervisor of Italy's banking system Draghi failed to discover or prevent loss-making derivatives trades at Monte dei Paschi.
(Writing by Paul Carrel/Mike Peacock, Additional reporting Annika Breidthardt. Editing by Jeremy Gaunt.)