By Tom Fairless 

FRANKFURT -- The European Central Bank is expected to extend its monetary stimulus on Thursday, but it is running out of room to keep buying bonds, the bank's most important tool for trying to bolster the eurozone economy.

With the ECB's balance sheet already hitting record highs and potential problems sourcing enough bonds, some economists and policy makers say the bank needs to figure out soon how to wind down its so-called quantitative-easing program.

Any discussion of tapering QE risks spooking investors at a sensitive political juncture. Four of the eurozone's five biggest economies, including Italy, look set for major elections next year, with anti-euro populists on the rise.

In the U.S., bond prices fell sharply and markets became choppy in 2013 when former Federal Reserve Chair Ben Bernanke suggested the central bank might slow its bond-purchase program.

"Signaling an eventual tapering of asset purchases now would almost certainly trigger...a 'taper tantrum' that might jeopardize the recovery and force the ECB to do more," said Frederik Ducrozet, an economist at Pictet Group in Geneva.

Italy in particular could quickly run into trouble if the ECB takes its foot off the gas. Interest payments on the nation's debt, which is around a third larger than its economy, are likely to surge if the ECB stops buying it, potentially jeopardizing Italy's position in the eurozone. Prime Minister Matteo Renzi resigned on Monday after voters rejected a proposed constitutional overhaul.

ECB President Mario Draghi has denied repeatedly that policy makers have even discussed tapering, and stressed that the bank's stimulus must be preserved for now.

Most economists expect the ECB to announce a six-month extension of QE on Thursday, probably at the current pace of EUR80 billion a month. The program had been due to expire in March.

But the purchases can't go on forever because the universe of assets is limited, and the path toward an exit must be mapped out early, economists said.

Changing asset-purchase programs is fundamentally different from tweaking short-term interest rates and takes much longer to execute, said Stefan Gerlach, deputy governor of Ireland's central bank until last year.

"For asset-purchase programs, a small modification risks leading to a devastating jolt to long yields and in bond prices, potentially triggering financial instability," said Mr. Gerlach, who is now chief economist at BSI Bank in Zurich.

Top ECB officials have recently highlighted the adverse side effects of the bank's stimulus policies, signaling that they may be approaching a turning point. Mr. Draghi warned last week that a lengthy period of low interest rates created "fertile terrain" for financial-market risks. In an interview published Nov. 30, the ECB chief suggested that a slower pace of bond purchases might be possible in combination with a longer extension.

Even that modest move might be risky, however, because it could be interpreted by investors as a move toward tapering.

"If the ECB were to commit to a nine-months extension of QE at EUR60 billion per month...many in the market would see this as a reduction in stimulus and a form of tapering," said Marchel Alexandrovich, an economist with Jefferies in London.

Policy makers are likely to be wary of taking such a risk now. Economic growth remains sluggish, and core inflation -- stripping out volatile food and energy prices -- was just 0.8% in November, lower than it was a year ago. The ECB aims to keep inflation just below 2%.

Jens Weidmann, president of Germany's Bundesbank and long an opponent of the ECB's bond purchases, called last month for "extra care" in deploying the bank's stimulus tools. He warned on Monday that central banks shouldn't use easy-money policies to fight debt crises or rising populism, signaling he would oppose any move to support Italy following that country's failed referendum.

Meanwhile, the ECB faces mounting challenges in finding enough bonds to buy. To extend QE by six months, the bank is expected on Thursday to change its self-imposed rules, which include strict limits on the yields and volumes of bonds it can buy.

Each of those changes could be problematic, potentially giving the central bank too much control over the bond market, or favoring some nations over others. A jump in bond yields following U.S. presidential elections has bought the ECB a little time, but not much. The ECB could turn to other assets, such as bank bonds or equities, but both could prove controversial.

Mr. Draghi could take a subtle approach to the tapering debate on Thursday. He could pledge, for instance, to regularly reassess the pace of bond purchases from the second half of next year. That way, the ECB chief could raise the possibility that purchases will slow later next year, without committing himself.

The ECB probably can't delay for long. Mr. Gerlach estimates the ECB will need more than a year to halt its purchases after announcing its intention to taper. In 12 months, the eurozone economy might look very different, particularly if the euro depreciates further against the dollar and governments in the U.S. and Europe increase spending.

ECB policy makers "don't want to take any risks right now, but at some stage they need to look for the beginning of an exit strategy," said Martin Lueck, chief German investment strategist at BlackRock Inc.

Write to Tom Fairless at tom.fairless@wsj.com

(END) Dow Jones Newswires

December 06, 2016 11:11 ET (16:11 GMT)