ECB under pressure to cut interest rates in face of growing deflation

The European Central Bank will face more than the usual level of scrutiny when its governing council gathers in Frankfurt today for its regular monthly rate-setting meeting. A series of economic indicators over the last few days suggests worrying signs that the euro zone's tentative economic recovery may be losing momentum.

On Tuesday the European Commission downgraded its forecast for economic growth for the euro zone next year. It now expects the euro zone eco- nomy to grow by 1.1 per cent in 2014, compared to its forecast of 1.2 per cent six months ago. Closely watched manufacturing figures – which give a snap- shot of how businesses across the continent are faring – showed a sharp decline in manufacturing activity across the EU, although with some notable exceptions, including Britain and Germany.

Of particular significance for the ECB, given its mandate to regulate inflation, is the deflationary trend that has begun to creep into the euro zone economy. Inflation fell sharply in October to 0.7 per cent – well below the bank’s target of keeping inflation “close to but below” 2 per cent.

ECB executive board member Benoit Coure warned last week that the euro zone could be facing a lost decade, similar to the period of stagnancy that engulfed Japan.

The accumulation of worrying economic figures has increased pressure on the bank to take action today in Frankfurt, despite the fact that interest rates are at a historic low of 0.5 per cent. While an interest rate cut is highly probable, some analysts expect that concrete measures will be postponed until December.

At the very least, ECB presi- dent Mario Draghi is expected to signal the bank's intention to take further stimulus action, whether through rate cuts or other forms of monetary easing, such as another bond-buying type programme.

The collection of economic data is a worrying sign for the euro zone economy, more than five years into the crisis.

Despite the fact that the euro zone officially emerged from an 18-month recession earlier this year with the bloc experiencing GDP growth of 0.3 per cent in the second quarter, the picture remains bleak.

Tuesday's economic forecast from the European Commission cut the growth prospects for virtually all countries in the euro zone. The reason, according to economic commissioner Olli Rehn, is a mixture of exter- nal factors, such as the recent slowdown in emerging economies, and internal factors, such as the continuing effect of an "ongoing necessary adjustment process" in euro zone countries as they continue to implement fiscal consolidation measures.

In particular, some of the euro zone's biggest economies are struggling to grow, with France and Spain scheduled to miss their deficit targets of 3 per cent of GDP set by the European Commission. The French economy is now forecast to grow by just 0.9 per cent next year, compared to 1.1 per cent predicted earlier this year, while Spain's growth projections have been revised down to 0.5 per cent from 0.9 per cent.

“The needs for economic reforms are of particular urgency and of particular importance” in France and Spain, Rehn said on Tuesday, a warning that Brussels’s policy of fiscal austerity shows no sign of abating in the immediate future.

Focus is also turning to Germany’s high current account surplus, indicative of the country’s booming export industry, which is benefiting from the weak euro.

The pattern of fragmentation is a feature of the economic picture across the euro zone, where peripheral countries are facing higher bank-funding costs than the stronger countries, a distortion that affects small businesses.

Nowhere is the division between stronger and weaker euro states more evident than in the labour market. Tuesday's economic forecast sees no let-up in the chronically high unemployment levels that have beset the euro zone's weaker economies. While Germany's unemployment rate is scheduled to gradually fall to 5.1 per cent by 2015, southern European countries such as Greece and Spain still face unemployment rates of up to 25 per cent over the next few years, with the percentage of people under 25 who are out of work reaching 60 per cent.

The European Commission’s latest forecast expects Greece’s unemployment rate to peak at 27 per cent this year, before reducing to 24 per cent in 2015, while Spain will continue to experience an elevated unemployment rate of more than 26 per cent this year and next, with an unemployment rate of 25.3 per cent scheduled for 2015.

"The differences in labour market performance across member states are expected to remain extremely large, with unemployment expected to range from 5 per cent in Austria to 26.5 per cent in Spain in 2014," the commission states in its economic forecast. It is a bleak picture and an issue that is likely to have a material impact on the outcome of next year's elections when Europeans go to the polls.