(Corrects interest rate in second paragraph of story first published Dec. 12)

Dec. 12 (Bloomberg) -- European Central Bank policy makers diverged on how much room they have to keep cutting interest rates as the euro region’s economy worsens.

Luxembourg’s Yves Mersch said today the ECB has already taken an “an extraordinary measure” by cutting the key rate to 2.5 percent this month and Germany’s Axel Weber said last night he “would like to avoid” taking it below 2 percent. At the same time, Portugal’s Vitor Constancio said today they still have a “margin of maneuver” to fight the risk of deflation

“The split on the council is out in the open now,” said Laurent Bilke, an economist at Nomura International in London who used to work at the ECB as a forecaster. “The fight isn’t so much about January, it’s about what the floor for interest rates is.”

As central bankers debate, Europe is slipping deeper into recession. European industrial production plunged the most in 15 years in October and French manufacturing confidence fell to a 21- year low in November.

ECB President Jean-Claude Trichet on Dec. 4 implied that there was a “consensus” on the governing council for this month’s 75 basis point reduction in borrowing costs, the biggest in the central bank’s 10-year history. Trichet described the previous month’s verdict as “unanimous.”

New York University professor Nouriel Roubini said the ECB is “behind the curve” and it should be cutting more aggressively.’’ The euro, which has dropped 8 percent against the dollar this year, was unchanged at $1.3341 today.

Intervention

The ECB’s benchmark is still the highest among the Group of Seven nations. The Bank of England’s benchmark is at 2 percent rate and the Federal Reserve’s at 1 percent. Investors are betting the Fed will halve its benchmark rate to 0.5 percent at its Dec. 15-16 policy meeting.

Constancio’s intervention today struck a different tone to that adopted in recent days by his ECB colleagues. While Mersch, Executive Board member Juergen Stark and Weber had signaled they are ready to ease the rate-cutting cycle, Constancio highlighted the deflationary dangers facing the economy.

“The risk of a significant recession exists and if it would materialize that would put a lot of downward pressure on inflation,” said Constancio.

Weber on the other hand told Boersen-Zeitung in an interview published yesterday that “we should be cautious when our rates approach territory we haven’t explored before.” The ECB’s benchmark has never dropped below 2 percent. Stark said Dec. 10 that scope for further rate cuts is “very limited, potentially allowing for small steps only.”

Too Optimistic

Investors are betting the deepening economic slump will push the ECB to slice another 50 basis points off the benchmark rate in January, Eonia forward contracts show.

“They will be forced to go to 1 percent or lower by June,” said Juergen Michels chief euro-area economist at Citigroup Inc in London. “The rhetoric at the moment is to justify their forecasts, which are too optimistic.”

Constancio and Cyprus’ Athanasios Orphanides also said over the past day that central bankers can still use unconventional measures if traditional policy is ineffective, a topic that Trichet has tried to avoid.

“In this context, we have to look into measures to promote the proper functioning of money and credit markets,” said Constancio.

ECB policy makers “have to wake up and smell the game,” said Jim O’Neill, chief economist at Goldman Sachs International in London. “Europeans have to realize they are on the same planet as everyone else.”

To contact the reporter on this story: Gabi Thesing in Frankfurt at gthesing@bloomberg.net

Last Updated: December 13, 2008 06:11 EST