Rate-Cutting Time in Europe?


European businessfolk have been clamoring for lower interest rates since the beginning of 2002, but the European Central Bank has steadfastly refused to budge. At long last, however, it looks as though the ECB is about to change tack. Although inflation is still hovering around 2%, the governing council is expected to lop at least 25 basis points off rates when it next meets on Dec. 5.

Why? According to senior ECB officials, the central bankers are finally waking up to the real state of euro-zone economy. In particular, they're worried about Germany -- Europe's largest economy -- which is hovering on the brink of its second recession in two years. German business confidence is at its lowest level for 10 months.

The ECB's own economic projections, which won't be made public until Dec. 12, are said to show that growth is slowing much faster than expected a month ago. Now, the euro-zone economy will be lucky to expand by 0.8% this year -- less than half the level the bank had predicted in June. In 2003, economists say growth should come in at around 1.8%, well below the 2.6% the ECB forecast in June.

TURNING DOVISH. Despite a slowing economy, rising unemployment, and feeble consumer spending, the monetary policymakers in Frankfurt have kept rates steady at 3.25% -- way above the 1.25% Fed funds rate in the U.S. Members of the ECB's 18-person governing council have repeatedly insisted they weren't able to give growth a boost because money supply was expanding faster than expected, and euro-zone inflation was above the 2% limit they consider consistent with price stability.

It was up to governments to give the economy a helping hand by cutting taxes, liberalizing labor markets, and making far-reaching structural reforms, they have argued all year. The ECB last cut rates on November 8, 2001. The U.S. Federal Reserve has moved twice since then.

ECB policymakers have started sounding more and more dovish in recent days, however. On Nov. 13, Ernst Welteke, head of Deutsche Bundesbank, Germany's central bank and one of the most influential members on the ECB's governing council, told journalists that "reading between the lines, [downside economic risks] suggest the rate path is heading down rather than straight ahead."

BALANCED RISKS? The bank also has more room to maneuver than it has had for months because money supply is finally starting to slow. Monthly M3 grew just 0.5% in October compared to 1.1% the previous month, according to Holger Fahrinkrug, who follows the ECB for UBS, the Swiss banking giant.

At the same time, inflation is trending back down. Having averaged 2.3% over the first 10 months of the year, it's expected to come in at under 2% for most of next year -- partly because of weaker growth and partly because the euro's recent strength has reduced prices for many imports, most notably oil and gas.

ECB officials are lining up to stress that inflation is no longer a threat. "The medium-term outlook for prices has improved," said Otmar Issing, the bank's chief economist, on Nov. 13. "The inflation outlook [at our last meeting on Nov. 7] was not clear." Three days later, executive committee member Sirkka Hamalainen, who is considered a monetary hawk, argued that "earlier we saw that inflationary risks were very balanced, but now there's some view that the risks are not that big."

"CLEAR THE DECKS." Robert Prior-Wandesforde, chief euro-zone economist at HSBC in London, points out that "such clear changes in ECB rhetoric have usually signaled an imminent rate move." Adding to the likelihood of a change in ECB policy: Plans are afoot in both Germany and France to narrow the two countries' budget deficits. Such moves will help reassure the ECB about the euro zone's future budgetary stance, especially the German government's aggressive fiscal-restraint plan.

The big question central-bank watchers are asking themselves is not whether the ECB will trim rates at their meeting on Dec. 5, but by how much? "A 50 basis points cut would remove any uncertainty from the markets and clear the decks for some time to come," says Prior-Wandesforde.

It would also surprise the markets, which are anticipating a 25-point move. The danger of cutting by just 25 points is that the markets will shrug their shoulders and say "So what?" But most economists believe a 25-point cut is more likely, signaling that the ECB remains fairly cautious about the inflation outlook. It would also pacify those members of the governing council -- mainly from countries like Spain and Ireland with relatively high growth and inflation rates -- who have reservations about cutting at all.

European business would far rather see a 50-point move. "That," says Daniel Julien, chairman of SR Teleperformance, a French call-center-management company, "would really give the economy the sort of kick that the U.S. economy, which is growing faster than Europe's, has had." But given the recent sluggishness of the Continent's economy, any cut is better than none at all. By David Fairlamb in Frankfurt


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