How Low Will Europe's Rates Go?

The ECB's cuts may not provide the stimulus it wants

It was a dramatic move. As concern mounted across Europe over deflation, recession, and joblessness, the European Central Bank cut interest rates on June 5 a full 50 basis points, from 2.5% to 2.0%. Note for history buffs: The last time rates were at this level in Europe, Otto von Bismarck was Chancellor of Germany, and Italy had just been unified. Just two years ago, rates were 4.75%. So what do Europe's businesses want now? Cheaper money. "We need more cuts to get people investing and spending again," declares Wolfgang Leese, CEO of Salzgitter, Germany's second-largest steelmaker. Even some members of the ECB governing council may want to get radical. At the June 5 meeting, insiders report, two council members raised the possibility of cutting rates by 75 basis points.

Cut rates. Cut them lower. Keep cutting. It's hard to believe this is happening in Europe, where, well into the latest downturn, the ECB under President Wim Duisenberg kept rates relatively high. That was in line with the bank's legal mandate to maintain price stability rather than keep the economy growing. But now Duisenberg, once the biggest monetary hawk on the planet, may not be finished with the scalpel. "If the U.S. has room to maneuver with an even lower interest rate level than we have, then you can imagine we have not exhausted our room to maneuver," he said at the June 5 meeting. Analysts now expect the ECB to slash rates to 1.75% or even 1.50% as soon as its meeting in September. "We're heading into a new environment of unprecedentedly low rates," says Karsten Junius, a central bank watcher at DekaBank in Frankfurt.

But what Duisenberg and the others haven't explored in public is a far scarier question: whether all the rate-cutting will make a difference. Cheap money spurred a boom in the Iron Chancellor's Germany, but it's hard to see that happening now. And the ECB has no tool except rate-cutting as it fights to revive growth. "In the U.S., [Federal Reserve Chairman Alan] Greenspan is talking about using unconventional methods to spur the economy," says Gwyn Hacche, an economist at HSBC (HBC ) Bank in London. "But the ECB's freedom is constrained by the Maastricht Treaty. It has less flexibility."

Given the dire state of the Continent's $8 trillion economy, pressure for further cuts is understandable. After all, euro-zone gross domestic product didn't grow at all in the first quarter of this year, and the German, Italian, and Dutch economies contracted. What's more, things aren't likely to improve anytime soon. According to the Kiel-based Institute for World Economics, the euro zone will be lucky to grow by just 0.6% over the year as a whole. If the second-quarter figures look as bad as economists think they will, the ECB will almost certainly act again. "Central banks in Europe are finally realizing that fighting recession is more important than fighting inflation," says Edgar Peters, chief investment officer of PanAgora Asset Management in Boston.

But the euro-zone economy may be so stalled that further cuts will do little good. There's even talk of a liquidity trap, in which monetary policy is rendered useless because there's more money than consumers and corporations are willing to spend -- the situation that is afflicting Japan. If a liquidity trap is set, it will be in Germany, the region's largest and sickest economy. In theory, lower rates should encourage companies and consumers there to borrow more to invest or spend. But even though the ECB has cut rates seven times since May, 2001 -- when they were at their peak of 4.75% -- German banks have boosted lending by less than 1%. With a recession, and with bankruptcies on the rise, banks are worried about being repaid. "We're caught in a credit crunch," says German Economics Minister Wolfgang Clement.

Worse, even if banks were willing to lend, companies may not be all that keen to borrow. That's because consumers, pinched by rising taxes and social-security contributions, are cutting spending and slowing corporate-revenue growth. At the same time, the euro has gained 24% on the dollar over the past 12 months, sapping the competitiveness of exporters. "In this environment, we would be reluctant to borrow no matter how low rates go," says a board member of one export-oriented company.

In fact, some critics say pushing interest rates down much further could cause as many problems as it solves. Cheaper money lightens the debt load on companies and countries. But lower rates could also persuade investors to stop buying government and other investment-grade bonds, possibly causing mayhem in the markets. Instead, they may seek higher returns in more risky plays such as junk bonds or stocks. That's especially true of institutional investors, who need to make 1% just to cover their costs. Says Len Riddell, an analyst at Irish stockbroker Goodbody: "Definitely at these levels, the squeeze is being felt."

The ECB chief will run other risks if he lets interest rates hit rock bottom. Countries on the periphery of Europe fear low rates will drive up spending, overheat their economies, and create inflation, which is already at 4.7% a year in Ireland and 3.7% in Portugal. Faster-growing nations worry that inflation could dent consumer purchasing power and hurt those who live on interest-driven fixed incomes, such as pensioners. "Because the ECB needs to look at the euro zone as a whole when setting rates, the Continent's biggest economy, Germany, will probably always end up with rates that aren't right for it," says Hacche of HSBC.

So what's a central banker to do? The ECB doesn't have a lot of options. It isn't allowed, for example, to provide funds on an unsecured basis to banks, something the Bank of Japan has tried in order to encourage more private lending -- so far unsuccessfully. And there are severe constraints under the rules of monetary union on how much liquidity national central banks, such as the Bundesbank, can pump into their countries' economies. Nor can the big nations at Europe's core do what the U.S. is doing and give themselves a fiscal boost by pouring money into public spending: They are already near or above the maximum 3% budget deficit allowed under the European Union's Stability & Growth Pact.

There are a few other options. The ECB could intervene in the currency markets to drive down the euro and give Europe Inc. a break on price competition. That seems unlikely. Another, more radical option would be to adopt officially and publicly an inflation target to bolster prices and consumer psychology. The ECB moved in that direction in May, when it declared that its definition of price stability was inflation below but close to 2%.

Few observers expect the ECB to resort to drastic tactics -- at least not yet. That's why Duisenberg keeps beating the drum about the need for governments to reform their economies themselves. "Structural reform would foster consumer and investor confidence and facilitate spending," he says. But that has been true for a decade or more in Europe. Today, that drumbeat is sounding a bit hollow.

By David Fairlamb in New York

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