Jan. 21 (Bloomberg) -- The European economy may be starting to suffer collateral damage from the U.S. subprime mortgage slump.

Banks are making borrowing harder, industrial production is shrinking and investor confidence is waning just as the U.S. skirts recession. With the euro's appreciation to a record hurting exports, more economists are betting the European Central Bank will be forced to lower interest rates.

``There is a clear downtrend in the economy now,'' said Michael Schubert, an economist at Commerzbank AG in Frankfurt. He revised his ECB forecast last week and predicts two cuts by October after previously projecting one in the final quarter.

The ECB has so far refused to follow the Federal Reserve and the Bank of England in lowering borrowing costs as contagion from the U.S. housing recession spreads, arguing that inflation pressures are too strong. Government and industry surveys this week may nevertheless show growth risks are mounting and finance ministers meet in Brussels today to discuss the outlook.

Europe's manufacturing and services industries probably expanded at the slowest pace since June 2005 and German business confidence fell to the lowest in two years, according to surveys of economists by Bloomberg News.

Europe's Dow Jones Stoxx 600 Index fell the most since the Sept. 11, 2001, terrorist attacks today and sank into a bear market. Today's declines follow the worst week for U.S. stocks in five years after the administration's $150 billion plan to revive the economy and expectations of interest-rate cuts failed to allay recession concerns.

`Excessive Volatility'

``The excessive volatility of the markets is not good news, but I hope they will become more quiet,'' European Union Monetary Affairs Commissioner Joaquin Almunia said today in Brussels where he is meeting with euro-area finance ministers. ``The markets are considering the possibility of a more- pronounced slowdown and even a recession in the U.S.''

The slowdown is undermining policy makers' hopes that the region will avoid the fallout from the subprime mortgage collapse, which drove up global credit costs.

Luxembourg Finance Minister Jean-Claude Juncker, who will chair today's talks, said Jan. 14 the European Commission may lower its growth projection for this year to 1.8 percent from 2.2 percent previously. That would be the slowest pace since 2005.

Industrial output fell enough in November for economists at Royal Bank of Scotland Group Plc to declare that manufacturing has slipped into its first recession since 2001, while investor confidence in Germany crumbled to the lowest since 1992.

European Banks

European banks will make it harder for companies and consumers to get loans in the next three months, an ECB survey showed on Jan. 18.

``The days of easy credit appear to be over,'' said Martin van Vliet, an economist at ING Bank in Amsterdam. Royal Bank of Scotland publishes the manufacturing and services reports on Jan. 23 and the Munich-based Ifo institute releases business confidence figures a day later.

Some officials including Fed Chairman Ben S. Bernanke argue the outlook for Europe is healthier than for the U.S. Aurelio Maccario, co-head of European economics at UniCredit Markets & Investment Banking, says there's no reason for ``doom and gloom'' given that only Ireland and Spain are threatened by the asset bubbles and the labor market continues to expand.

``We do not see in Asia or in Europe the slowdown in growth that potentially we'll be seeing here in the U.S.,'' said Bernanke on Jan. 17.

Europe's Economy

Still, the tightening of credit threatens to cool company investment, a plank of Europe's economy last year. Ifo said Dec. 12 it expects investment spending in Germany to grow about 4 percent this year, less than half the rate of 2007. Stephane Deo, a UBS AG economist, predicts company profit margins will shrink this year for the first time in a decade.

Support from trade is also being eroded by weaker foreign demand and the stronger euro. Shipments rose just 0.3 percent in November from a month earlier, a quarter of October's increase, the EU's statistics office said Jan. 17.

With sales to the U.S. already shrinking as the dollar falls, exports to Britain, the euro region's biggest trading partner, are also coming under pressure. The pound has dropped 11 percent against Europe's single currency in the past five months.

``Euro-zone exporters will find life increasingly difficult,'' said Howard Archer, chief European economist at Global Insight Inc. in London. The euro has appreciated 12 percent against the dollar in the past year.

ECB's Target

The worsening outlook may divide opinion on the ECB's 21- member governing council in coming months. While President Jean- Claude Trichet warned Jan. 10 that the bank would act ``preemptively'' if inflation began pushing up wages, other council members have toned down their language. Inflation accelerated to 3.1 percent in each of the past two months, the highest since May 2001 and above the ECB's target of just below 2 percent.

ECB Executive Board Member Juergen Stark today said the bank stands ready to raise interest rates to counter inflation.

``We're sticking to our assessment that, based on current data, growth will be around potential in 2008,'' Stark said in an interview in Viernheim, Germany, today. ``I want to repeat that we have said that we will do what is needed to avoid so- called second-round effects. We are ready to act.''

By contrast, Luxembourg's Yves Mersch said in a Jan. 15 interview that the bank should exercise caution amid ``downside risks to economic activity,'' while Germany's Axel Weber cautioned not to ``over-dramatize'' a pick-up in inflation.

`Shift in Tone'

``Cracks are starting to show,'' said Ken Wattret, chief euro-area economist at BNP Paribas SA in London. ``The shift in tone is significant.''

Economists are scaling back their 2008 rate forecasts. Those at ABN Amro Holding NV now expect the ECB's benchmark to stay at 4 percent this year, having previously anticipated an increase to 4.25 percent, while David Owen, chief European economist at Dresdner Kleinwort Group in London, predicts a rate cut by the end of the year.

Michael Hume, chief European economist at Lehman Brothers Holdings Inc., likens the period to 2001 which the ECB began by betting it could avoid the effect of a U.S. slowdown. By May, it was cutting rates.

``We suspect the governing council has not forgotten that lesson,'' said Hume.

To contact the reporter on this story: Simon Kennedy in Paris at skennedy4@bloomberg.net

Last Updated: January 21, 2008 11:09 EST