Commentary: Rates: Europe Needs a Lift-Off, Too
By David Fairlamb
The economy of the 12-nation euro zone is slowing, just like its counterparts in the U.S. and Asia. But don't look to the European Central Bank to follow the U.S. Federal Reserve with interest rate cuts just yet. The monetary conservatives who dominate its 18-member governing council see their role as fighting inflation rather than stimulating growth. So with prices rising at an annualized 2.6%--well above the 2% upper limit the ECB says is consistent with price stability--the central bankers aren't in a rush to push the price of money down below the current 4.75%.
Most ECB watchers don't expect the bank to make a move before the middle of April. And when it does act, predicts Jose Luis Alzola, who follows the bank for Schroder Salomon Smith Barney in London, it will be with a modest rate cut of 25 basis points. The Fed, by contrast, has lopped 150 basis points off U.S. rates since the beginning of the year.
SUBDUED. The ECB's caution might make sense if inflation were really a threat. But it's not. Break down the figures, and it's evident that fast-rising energy prices--up 13.3% in 2000--are the main factor behind last year's upswing in headline inflation. Core inflation, which excludes the cost of energy, remains subdued at less than 2%.
Now that energy prices are falling, inflation should quickly slow. "In that environment, cutting interest rates won't endanger price stability," says Julian Callow, an economist at Credit Suisse First Boston in London. "There are no compelling reasons why the ECB shouldn't cut."
But there are plenty of reasons why it should. A cut now would give the European economy a much needed boost. Euro zone growth peaked at only 3.5% last summer and will likely fall to 2.8% for all of 2001.
Tax cuts worth 0.8% of the euro zone's gross domestic product have bolstered domestic demand a bit, but not enough to make up for the effects of the global slowdown. The ECB insists Europe won't be badly hurt by the economic downturn in the U.S. and East Asia. But businesspeople aren't convinced. "We're living in an increasingly synchronized world," says Jon Chait, chairman and chief executive of Spring Group PLC, which specializes in recruitment for the information technology sector. "Europe can't protect itself from what's happening elsewhere."
That's why manufacturers say cheaper money is needed to give euro zone companies a lift. Non-European monetary officials, meanwhile, note it would give the flagging global economy a welcome fillip as well. "The ECB should cut rates and help start the world growing again," says a central banker from outside the euro zone. "It's the only major central bank that hasn't loosened policy this year."
A rate cut would also benefit the euro. After a short-lived rally early this year, the currency looks sickly again. It fell temporarily below the psychologically important 90 cents level on Mar. 16. That's because investors assume the U.S. economy, helped by Fed cuts, will soon pick up speed and overtake the euro zone again. There's now only a 25-basis-point difference between U.S. and euro zone rates--even though U.S. inflation is almost 1% higher at 3.5%. By bucking the rate-cutting trend, the ECB acts as a growth inhibitor. "That puzzles investors--who ditch the euro as a result," says Callow.
The ECB can't afford to drag its feet much longer. If it waits until the economy takes a dramatic dive, as some predict it will, it will be too late. Economists say it takes from 9 to 18 months for monetary moves to feed through into growth in Europe. So decisions the central bank takes now may not have an impact until yearend. Given that, the ECB should lop 50 basis points off rates at its Mar. 29 meeting. That could begin to reverse the slowdown. It might also help Continental equity markets and attract capital into the euro zone, strengthening the currency. The stronger euro would help quell inflation by driving down the price of imports. Even monetary conservatives should find that prospect appealing.
Fairlamb reports on European finance from Frankfurt.