ECB Expected to Slash Interest Rates

It appears to be a done deal. Europe’s central bankers are to gather in Frankfurt on Thursday to lower borrowing costs in the 12-nation euro zone. The only question for many observers is whether the European Central Bank (ECB) will slash interest rates by a quarter of a percentage point or by a whopping half point -- known respectively as 25 or 50 basis points in the financial markets.

“It smells a lot like 50 basis points,” Volker Nitsch, senior economist for Bankgesellschaft Berlin, told Deutsche Welle. “Quite a few things point toward a bigger cut. Maybe just to fulfill market expectations.”

The ECB’s main refinancing rate is already at a low 2.50 percent, but Europe’s economies have stalled in recent months. Lower interest rates would help spur growth by making it easier for companies and individuals to borrow capital. The region’s largest economy, Germany, grew a meager 0.2 percent in 2002 and technically slipped into recession after gross domestic product actually shrank in the first quarter of this year.

Rising euro adds to the pain

Germany, which accounts for around a third of total euro zone output, has ground to a halt under the weight of its generous welfare system and constricting labor market policies. Adding to the misery, the euro has has surged in value against the U.S. dollar in recent months, causing the country’s export-led economy to suffer even more as German goods have become more expensive abroad.

The euro -- at $1.17 on Wednesday -- has gained around 12 percent against the greenback since the beginning of the year. And since many products such as oil are dollar-denominated, inflation in Europe has begun to slow dramatically, raising the specter of deflation -- where prices continue to sink and consumers put off purchases crippling the economy as has happened in Japan.

"The German economy is basically stagnating. The financial sector has experienced difficulties and this economy obviously shows some similarities to the Japanese economy in the early nineties,” Bundesbank President Ernst Welteke told reporters on Tuesday.

Welteke, Germany’s top central banker and ECB council member, attended a monetary conference in Berlin along with ECB President Wim Duisenberg, Bank of England Governor Eddie George and U.S. Federal Reserve Chairman Alan Greenspan.

“I don’t want to completely rule out deflation in Germany, but I’m a bit skeptical. However, there’s no point in closing our eyes and saying it definitely can’t happen here because that’s just what happened in Japan,” said Bankgesellschaft’s Nitsch. “But there was a broad consensus at the conference in Berlin on Tuesday that the world economy will slowly begin to recover.”

Structural reforms needed

Although several euro zone leaders including German Chancellor Gerhard Schröder have called on the ECB to lower rates to help growth, Nitsch said the role of monetary policy shouldn’t be exaggerated. He said cheaper capital certainly wouldn’t hurt the economy, but that Europe also needed to embrace structural reforms, including making labor markets more flexible.

Stefan Schneider, an economist for Deutsche Bank in Frankfurt, agreed over the long-term the euro-area countries would have to restructure their economies to achieve better growth. But he said Europe’s central bankers could have followed the lead of the U.S. Federal Reserve and cut borrowing costs earlier and further than they have.

“The ECB probably could have cut rates one or two months ago, so you could say they are reacting a little late,” Schneider told Deutsche Welle. “But they likely didn’t want to respond too quickly to the euro’s rise, since the currency markets can change at a moment’s notice and make a central banker look rather dumb.”

However, he also said even with Thursday’s expected cut in interest rates, the German economy likely wouldn’t manage to turn things around without a global recovery.

“Germany won’t manage it on its own,” he said.