By Eva Taylor and John O'Donnell
FRANKFURT (Reuters) - The European Central Bank could buy loans and other assets from banks to help support the euro zone economy, Germany's Bundesbank said, marking a radical softening of its stance on the contested policy.
The ECB has cut interest rates to a record low and promised to keep them low for some time, having also flooded the banking system with cheap crisis loans. But the euro zone economy is still weak and inflation remains stuck well below the central bank's target.
With the debate over possible alternative measures picking up pace, Bundesbank President Jens Weidmann said the ECB could consider purchasing euro zone government bonds or top-rated private sector assets.
That opened the door to one of the most divisive policy options - quantitative easing (QE) - and one that the German central bank has consistently viewed critically.
"Of course any private or public assets that we might buy would have to meet certain quality standards," Weidmann, who is a member of the ECB's Governing Council, said in an interview with MNI published on Tuesday.
"But the overall question is one of effectiveness, costs and side-effects. We are currently discussing the effectiveness of these measures. The intended effects would then have to be weighed against the costs and side-effects."
ECB President Mario Draghi in Paris stressed the ECB's readiness to act should inflation come in below expectations.
For now, there was no need to act, Weidmann said, but if the outlook for inflation changed, for example as a result of a stronger euro exchange rate, the ECB could step in, most likely with another interest rate cut and possibly even QE.
Another cut of the main refinancing rate would likely push the deposit rate into negative territory, which would mean that banks have to pay to park their funds at the ECB overnight.
The ECB has so far held off from that because of possible side effects, but Finnish governor Erkki Liikanen said a negative deposit rate was no "longer a controversial issue".
The euro fell temporarily after policymakers signaled potentially more monetary easing to around $1.3780. The European Commission' vice-president for industry, Antonio Tajani, had said earlier at $1.40 the euro was too strong.
Slovakia's central bank governor Jozef Makuch said the currency should weaken by the end of the year.
The ECB has started to pay closer attention to the euro exchange rate and its impact on the outlook for inflation, and Weidmann said a negative deposit rate could be a way to address the impact of a strengthening currency.
"If you wanted to counter the consequences of a strong appreciation of the euro for the inflation outlook, negative rates would, however, appear to be a more appropriate measure than others," he said. "But we are talking about hypothetical scenarios here and not about imminent decisions."
The impact such a step would have to improve bank lending to companies and households was, however, "debatable", he said.
The Bundesbank represents the 18-member euro zone's biggest economy, Germany, and its president's words carry weight in the debate over what the ECB should do as traditional tools such as changing borrowing costs lose their force.
Weidmann cited limits under the ECB's mandate on funding governments, which a pending German constitutional court ruling on the legality of the Outright Monetary Transactions (OMT) bond purchase program is expected to underline.
"This does not mean that a QE program is generally out of the question. But we have to ensure that the prohibition of monetary financing is respected," Weidmann said.
"We need to discuss this and ideally achieve a common view."
The ECB's Liikanen and Makuch also did not rule out QE.
Asked by the Wall Street Journal whether government bonds purchases by the ECB violated the EU treaty, Liikanen said: "That's not a legal problem. The treaty allows the purchases from the secondary markets."
QE would represent a radical departure for the ECB, which has so far refrained from taking such a step also because it is such a highly political issue in the euro zone.
Weidmann's predecessor Axel Weber resigned in 2011 in protest at the ECB's first government bond purchase program at the height of the euro zone debt crisis and Weidmann was the only Governing Council member to vote against the OMT in 2012.
The Bundesbank is concerned about overstretching the ECB's mandate of preserving price stability and venturing too far into the realm of financing governments by buying sovereign debt, something that it is banned from doing under EU law.
(Writing by Eva Taylor. Additional reporting by Robert Muller in Bratislava, Leigh Thomas in Paris and Sakari Suoninen in Helsinki, Editing by Jeremy Gaunt, John Stonestreet)