The Euro Zone: Will the Central Bank Give Germany a Break?

The European Central Bank is in a quandary. Growth in the euro zone is weak and fading, but areawide inflation remains above the ECB's 2% limit. So pressure is growing from both Germany and France to cut interest rates now.

After posting a 1.5% annual rate of growth in the first half, the euro zone economy struggled to match that pace in the third quarter. Plus, industrial data through September showed a steep loss of momentum over the third quarter, meaning that fourth-quarter growth will be slower still. The German economy could even contract this quarter.

At the same time, the ECB is caught between German and French fiscal policies. The deficits of both countries are excessive by euro zone standards, but the ECB cannot make policy favorable to Germany, which is attempting to limit its budget overruns, since a rate cut would also benefit France, which is openly refusing to tighten its budget.

For now, the ECB seems in no hurry to ease policy. It held rates steady at 3.25% on Oct. 10, citing balanced risks to price stability. The rate has been unchanged for nearly a year. Still, the ECB's Monthly Bulletin sounded slightly less hawkish. The bank emphasized the risks to growth from the plunge in stock prices, and while September inflation remained at 2.1%, the bank noted inflation expectations have been falling this year. That's because businesses say pricing power is nil. And with growth expected to continue below the euro zone's 2%-to-2.5% potential growth rate well into 2003, inflation should fall, barring another spike in oil prices.

The main risk is an economic slump, not inflation. Businesses have pulled back amid heightened uncertainty after the drop in stock prices, and they are hesitant to build inventories. And with domestic demand still weak, the falloff in global demand is further hurting orders and industrial output. This scenario is hitting Germany especially hard. Indeed, the ECB's policy choice may well come down to sacrificing Germany to recession in order to assure price stability across the region.

By James C. Cooper & Kathleen Madigan

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