Commentary: The ECB: Cut Soon, Cut Again

By David Fairlamb

Inflation is in retreat all across the euro zone, and the consumer price index in Germany is dropping like a stone. So it's hardly surprising that the European Central Bank looks set belatedly to lop 50 basis points off interest rates when its governing council next meets, on June 5. Even the monetary hawks at the bank's Frankfurt headquarters now accept that a hefty cut in its key 2.5% rate is needed to kick-start the flagging Continental economy. As ECB Vice-President Lucas Papademos pointed out on May 27, "deflation is more undesirable than inflation above 2%." That figure is the limit the ECB deems consistent with its legal mandate to maintain price stability.

But a rate cut is not enough. More radical action is needed from both monetary and fiscal policymakers to ensure that Germany, already mired in its second recession in as many years, does not slip into Japanese-style deflation. The German CPI recorded only a 0.7% increase in May, and economists say it will turn negative by early next year. If that happens, it will be more difficult for the country's floundering $2.4 trillion economy to pull itself out of recession.

Given the risks, the ECB should cut interest rates further, by at least another 50 basis points, in the second half of this year. To be sure, the ECB can't take just German needs into account when setting rates: The Maastricht treaty says it must think about the euro zone as a whole. But Germany is by far Europe's biggest economy, and a deflationary Germany could drag the rest of the region down with it. There's no other way around it: Save Germany, save Europe's economy. Lose Germany, and... well, you get the idea.

Besides, even by its own rules, the ECB does have room to maneuver. On May 28, Chief Economist Otmar Issing said he expected a "clear" drop in euro-zone inflation, which was 2.1% in April, in the coming months. Private-sector economists say the rate could fall to 1.4% by the end of the year. David Bloom, a currency strategist at HSBC Bank in London, points out that the 9.5% rise in the value of the euro since January has had the same impact on the euro-zone economy as a 75-basis-point interest-rate increase. So the ECB needs to cut more than 50 basis points to give the economy a real boost.

Politicians must also do their part. They need to free themselves temporarily from the constraints of the Stability & Growth Pact, which limits budget deficits to 3% of gross domestic product. Budgetary discipline may be desirable, but not in a country with Germany's ills. Relaxing the rules would allow Berlin to stimulate growth by cutting taxes and increasing public spending.

Most important, the Berlin government must finally tackle its own structural problems -- such as rigid labor laws, a complicated tax system, and high social security costs -- that weigh heavily on German companies and hold back growth. The International Monetary Fund and the Organization for Economic Cooperation & Development have both said in recent days that such reforms are essential to get the economy growing. If they are unpopular, so what? Without them, Germany and the rest of the euro zone risk being sucked into a deflationary spiral from which it will be hard to escape.

Fairlamb writes about European finance from Frankfurt.

    Before it's here, it's on the Bloomberg Terminal.