Europe’s Stalling Economy May Keep ECB Interest Rate on Hold

Europe’s unexpectedly sharp economic slowdown has increased the risk of another recession and may prevent the European Central Bank from raising interest rates again this year.

The 17-nation euro-area economy may struggle to gather momentum after growing just 0.2 percent in the second quarter, its worst performance since emerging from the last recession in 2009, said economists including Marco Valli at UniCredit Global Research and Stewart Robertson at Aviva Investors. France’s economy stagnated and in Germany, the region’s economic engine, expansion almost stalled.

“I’m comfortable believing that this is a temporary slowdown, but the focus will remain on recession risks for the next few months,” said Valli, chief euro-region economist at UniCredit in Milan. “Rate hikes are off the table for now.”

Europe’s weakness may persist for the remainder of the year as governments from Ireland to Italy cut spending to rein in ballooning budget deficits and the global economy cools. The ECB, which has raised its benchmark rate twice this year to 1.5 percent to tackle inflation, was last week forced to start buying Italian and Spanish bonds to stop the region’s sovereign- debt crisis from spreading.

Merkel, Sarkozy

The euro declined and stocks fell after yesterday’s gross domestic product data, which added to evidence of a global economic slowdown. German Chancellor Angela Merkel and French President Nicolas Sarkozy later proposed to establish an euro- area economic council and to seek a tax on financial transactions as they try to stem the region’s turmoil.

Europe’s debt crisis, having prompted bailouts of peripheral nations Greece, Ireland and Portugal, is now affecting confidence in the region’s core economies. German GDP rose 0.1 percent in the second quarter; the median forecast of economists was for 0.5 percent growth.

“The weak GDP print piles pressure on euro-zone authorities to come up with a structural solution to the debt crisis,” said Martin van Vliet, senior euro-area economist at ING Bank in Amsterdam, who hasn’t discounted the possibility of a recession. “Much depends on whether further contagion from the financial-market turbulence to consumer and business confidence will be avoided.”

Euro Bonds

Merkel and Sarkozy, after meeting in Paris yesterday, said jointly issued European bonds aren’t an immediate solution to the crisis. So-called euro bonds may be “imaginable one day,” Sarkozy said.

A faltering global recovery is compounding Europe’s problems. Euro-area exports dropped a seasonally adjusted 4.7 percent in June from the previous month, the European Union’s statistics office in Luxembourg said yesterday.

Growth in the euro-area manufacturing industry, as measured by the Markit purchasing managers’ index, last month slowed to the weakest pace in two years. Markit chief economist Chris Williamson said next week’s PMI for August “will give an important insight into whether the soft-patch could turn into contraction.” Weaker data “could prompt a hasty reversal” from the ECB on interest rates, he said.

The ECB, which is due to update its economic forecasts next month, “will probably say growth risks have moved to the downside,” said UniCredit’s Valli. “I don’t think that we’ll see a rate cut, even though that’s something the markets are going to speculate about.”

Slowing Inflation

The euro area’s inflation rate fell to 2.5 percent in July from 2.7 percent in June, the European Union’s statistics office in Luxembourg said today. The ECB aims to keep inflation just below 2 percent.

Robertson, London-based chief European economist at Aviva Investors, which manages $371 billion in assets, said while the euro area is likely to avoid recession, sluggish growth will keep ECB rates on hold well into 2012.

“I had penciled in a rate increase from the ECB every quarter,” he said. “It now looks less likely that they’ll do that.”

Economic uncertainty is “particularly high,” ECB President Jean-Claude Trichet said on Aug. 4, while maintaining that risks to the outlook are “broadly balanced.”

U.S. industrial production climbed in July by the most this year, figures from the Federal Reserve showed yesterday, as carmakers started to shake off the effects of the disaster in Japan and higher temperatures boosted utility use.

Spring Weather

In Germany, mild spring weather led to construction work being brought forward, which boosted first-quarter GDP figures at the expense of the second quarter, according to Joerg Kraemer, chief economist at Commerzbank AG in Frankfurt. “Without this effect, second-quarter GDP would have grown by 0.4 percent rather than 0.1 percent,” Kraemer said.

German firms including Siemens AG, which reported record order backlogs in recent months, may be able to maintain production even as global growth slows.

“The focus is now on what the third quarter looks like, and the big question is whether growth stabilizes at current levels or drops further,” said Jens Sondergaard, senior European economist at Nomura International PLC in London, who expects the Frankfurt-based ECB to enter wait-and-see mode. “While this is a sharp slowdown, talk of an ECB rate cut is premature.”

To contact the reporters on this story: Christian Vits in Frankfurt at cvits@bloomberg.net; Jeff Black in Frankfurt jblack25@bloomberg.net

To contact the editor responsible for this story: Craig Stirling at cstirling1@bloomberg.net

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