What Will It Take Before Europe Cuts Rates?


The economy of Continental Europe's euro zone is sputtering. Yet, the European Central Bank held rates steady again at its meeting on July 5, surprising outsiders, who had expected the ECB to lop at least 25 basis points off its key refinancing rate, which is now at 4.50%.

In sharp contrast to the U.S. Federal Reserve, which has cut rates six times this year, and the Bank of England, which has cut rates three times, the ECB has cut rates only once -- from 4.75% to 4.50%, on May 10.

The reason for the differing approaches? ECB officials are far more focussed on inflation than their counterparts in Washington and London. They contend that they couldn't reduce rates because inflation -- which hit 3.4% in the euro zone last month -- is well above the upper limit of 2% that the ECB says is consistent with price stability.

Europe's money supply also increased faster than expected in May, which could feed through into higher prices. "I don't see any reason to reduce rates," says ECB President Wim Duisenberg. "The current monetary policy stance is appropriate and, in the opinion of the governing council, remains appropriate for some time to come."

The word in Frankfurt is that two of the most influential council members -- Bundesbank President Ernst Welteke and Banque de France Governor Jean-Claude Trichet -- were thought to favor a cut. But the year-on-year rate of M3 money-supply growth unexpectedly increased in May -- to 5.4%, up from 4.8% in April. That made it hard to cut rates because the ECB has "a twin pillar" approach, which takes account of both money supply and inflation when setting monetary policy.

INVESTMENT FALLING. "If M3 had continued to fall, they could have justified a cut to the markets," says an official at one European central bank. "But the rise made it impossible because the situation looked bad on both the money supply and inflation fronts."

Now, pressure is mounting from European industry for a change of policy. Many of the 650 business executives, economists, and academics who attended the European Economic Summit in Salzburg from July 1 to July 3 argued that inflation -- even at 3.4% -- is not a problem that can be solved by keeping interest rates high. "It is the result of higher-than-expected energy prices and food prices," says Vicky Pryce, chief economist at consulting firm KPMG. "Those are now declining, so overall inflation will go down, too. Higher interest rates aren't necessary. The ECB should cut them."

Lower interest rates, executives argue, would boost euro zone corporate investment, which declined 0.9% in the first quarter of this year. Flagging business confidence also might be bolstered. The INSEE index, which measures French business confidence, has fallen rapidly over the past five months. So has its German counterpart, the Ifo index. "The ECB is too hesitant and the economy in Europe and Germany is being hobbled as a result," says Herbert Meyer, chief financial officer of Heidelberger Druckmaschinen, a printing-machinery manufacturer. "Inflation is not a particular risk. Another rate cut is overdue."

EUROPE'S MALAISE. Skeptics note that there are glimmers of economic improvement in both the U.S. and England. But Continental economies continue to slump. France will be lucky if its economy expands by more than 1% this year. Germany is doing even worse. Its economy, the euro zone's largest, probably didn't expand at all in the second quarter, says Economics Minister Werner Mler, while unemployment rose to its highest level in two-and-a-half years in June. Meantime, companies across Europe are lining up to issue profit warnings. KLM Royal Dutch Airlines and Heidelberger Druck are among more than a dozen companies that have issued warnings in recent days.

The betting is that the ECB will eventually raise rates, but possibly not until this fall. That's bad news for industry and the euro, which slipped below 84 cents within minutes of the ECB decision. For now, it's still watch-and-wait for the ECB. By David Fairlamb in Frankfurt, Germany


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