July 15 (Bloomberg) -- German investor confidence fell to a record low in July as surging inflation and higher interest rates dimmed the outlook for growth in Europe's largest economy.

The ZEW Center for European Economic Research in Mannheim said its index of investor and analyst expectations dropped to minus 63.9, the lowest since it was first compiled in December 1991, from minus 52.4 in June. Economists expected a decline to minus 55, the median of 37 forecasts in a Bloomberg survey shows.

Surging oil and food prices prompted the European Central Bank to raise its key rate by a quarter point to 4.25 percent this month, further squeezing purchasing power. As a stronger euro weighs on exports and the U.S. housing slump damps confidence worldwide, Germany's benchmark DAX share index has dropped 7 percent in the past month and 23 percent this year.

``It will be crucial to see not whether the economic slowdown takes place, but to what extent,'' said Andreas Rees, chief economist for Germany at UniCredit Markets & Investment Banking in Munich. ``Future development in the index hinges on how the U.S. deals with problems at Fannie Mae and Freddie Mac.''

The dollar dropped to $1.6038 against the euro today, the lowest since Europe's single currency started trading in 1999. It extended this year's 10 percent slide partly on concern that confidence in the debt of Fannie Mae and Freddie Mac, which buy or finance almost half the $12 trillion of U.S. mortgages, will deteriorate even after the U.S. government pledged support.

European Slowdown

European government bonds extended gains after the ZEW figures, pushing the yield on the German 10-year bund 4 basis points lower to 4.36 percent at 1:21 p.m. in London. ZEW's survey aims to predict economic activity six months in advance. A negative reading means pessimists outnumber optimists.

Growth is slowing across Europe's economy. Confidence among French manufacturers fell to the lowest in five years in June, the country's central bank said today, and European industrial output fell the most in almost 16 years in May. The U.K.'s economy is edging closer to a recession as house prices decline.

``Expectations are very negative, reflecting increased global risks,'' said Sandra Schmidt, an economist at the ZEW. ``We have very high oil prices, the strong euro, which appreciated further, the U.S. crisis, the ECB has raised interest rates and also consumer demand should continue to weaken.''

Second Quarter

Heidelberger Druckmaschinen AG, the world's largest printing- press maker, said last week demand faces a ``prolonged'' slowdown. Germany's economy probably shrank in the three months through June, Deputy Economy Minister Walther Otremba said last month.

``I don't believe in a recession, but we'll see a strong contraction in the second quarter,'' Unicredit's Rees said.

The ECB and other central banks are finding it difficult to cut rates as inflation accelerates. Euro-region consumer prices jumped 4 percent in June from a year earlier, the highest in more than 16 years. British inflation accelerated to the fastest pace since at least 1997, the country's statistics office said today.

Oil prices have almost doubled in the past year and reached a record $147.27 a barrel last week.

Traders reduced bets the ECB will increase rates further this year. The implied rate on December Euribor interest-rate futures contracts fell to 5.03 percent, from 5.28 percent on July 2. Bank of England policy maker Kate Barker said this week that ``we are all worried'' about ``holding policy too tight'' in the U.K.

Strong Euro

A stronger euro is putting pressure on German exporters already coping with a slowing global economy, while the crisis in U.S. subprime mortgages has roiled financial markets and damped the outlook for global growth. The world's biggest financial companies have posted more than $415 billion in writedowns and credit losses since the start of last year.

``The cooling of world economic activity will damp foreign sales and the stronger euro is an additional restricting factor,'' according to the Ifo economic institute.

Still, Germany's gross domestic product, which accounts for about a third of the euro-region economy, rose 1.5 percent in the first quarter from the previous three-month period as companies stepped up spending on machinery and construction.

Deputy Finance Minister Joerg Asmussen said today that Germany will cope with global economic risks and growth of 1.7 percent this year is ``realistic.''

``The ZEW is an exaggeration to the downside,'' said Claus Meyer-Cording, who helps oversee the equivalent of $15 billion in euro-denominated bonds at DWS Investment GmbH in Frankfurt. ``I believe it's time for modest optimism as a lot of negative factors are already priced in.''

To contact the reporter on this story: Christian Vits in Frankfurt cvits@bloomberg.net.

Last Updated: July 15, 2008 08:32 EDT