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ECB doves make case for increased caution in policy tightening

FILE PHOTO: Interview with ECB's policymaker Visco in Rome

By Stefano Bernabei and Jesús Aguado

ROME/MADRID (Reuters) -The European Central Bank must continue to raise interest rates but there is a growing case for increased caution in policy tightening after a string of aggressive moves, two key policy doves argued on Wednesday.

The ECB has raised rates by a combined 200 basis points since July, its fastest ever pace of tightening and it will soon start running down its 8.7 trillion euro ($9.1 trillion) balance sheet by letting debt expire and encouraging banks to repay central bank funding.

"The need to continue with restrictive policy is ... evident, although reasons to follow a less aggressive approach are gaining ground," Bank of Italy Governor Ignazio Visco, said in a speech in Rome.

He warned of the risk of policymakers being set on a pre-determined path and said future monetary policy decisions must be based on data and evidence.

Spanish central bank chief Pablo Hernandez de Cos also sounded caution, arguing that even if there was "some way to go" with rate hikes, any reduction in the ECB's balance sheet must be "very gradual".

De Cos said the bank must also take into account a higher probability of a recession and should keep in mind that a rapid reduction in bond holdings could trigger market volatility.

"All these arguments point, in my view, to the need for the balance sheet reduction in the euro area to be very gradual and predictable," he said.

De Cos also argued that the ECB should first absorb the impact of commercial banks repaying ultra cheap funding to the ECB over the coming months before it stops fully re-investing expiring debt.

Markets currently see the ECB's 1.5% deposit rate rising to 2% in December but investors also see a fair probability of a bigger move to 2.25%.

While policymakers have long argued that longer-term inflation expectations remain "anchored" near the ECB's 2% target, both survey and market-based measures are trending up, holding slightly above the target, pointing to a greater risk of a persistent overshoot.

Turning to Italy, Visco called on Giorgia Meloni's new government to show "prudence and responsibility" with public finances, while pursuing reforms to raise the country's growth potential.

Visco said it was "certainly not advisable" for Rome to rely on inflation to rein in a public debt which stood at 150.3% of national output at the end of last year.

The Treasury is targeting the debt ratio at 145.7% this year and 144.6% in 2023.

($1 = 0.9606 euros)

(Writing by Cristina Carlevaro and Balazs KoranyiEditing by Gavin Jones, Mark Potter and Tomasz Janowski)