December 4, 1998

European Banks, Acting in Unison, Cut Interest Rate

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    FRANKFURT, Germany -- In the most coordinated action yet toward European monetary union, 11 nations simultaneously cut their interest rates Thursday to a nearly uniform low level.

    The move came a month before the nations are to adopt the euro as a single currency and marked a drastic shift in policy. As recently as two months ago, European central bankers had adamantly refused to lower rates because they were intent on establishing the credibility of the euro and the fledgling European Central Bank in world markets.

    But on Thursday, citing signs that the global economic slowdown has begun to chill Europe, the central banks of the 11 euro-zone nations reduced their benchmark interest rates by at least three-tenths of a percent. The cuts are intended to help bolster the European economies by making it cheaper for businesses and consumers to borrow.

    When the dust settled, every country in the euro zone except Italy had reduced its key interest rate to 3.0 percent. Germany's powerful Bundesbank, which has long been the benchmark for all the others, cut its basic rate from 3.3 percent. Italy, which has had some of the highest rates in Europe, dropped to 3.5 percent from 4 percent. The key rates are comparable to the Federal Funds rate in the United States, the target rate for overnight loans between banks, which is now 4.75 percent.

    "Convergence is now complete," said Holger Fahrinkrug, head of Economic Research at the Frankfurt office of Warburg Dillon Read. "We have arrived."

    The rate reductions are unlikely to have a direct influence on U.S. rate policy, but they could aid the American economy by strengthening the market for goods in Europe and by helping bolster the world economy.

    Though most economists had expected the new European Central Bank to lower interest rates early next year, almost everybody was surprised when the national central banks settled the issue before the new bank officially assumed responsibility for European monetary policy.

    The decision came after months of bitter and public battles between Europe's conservative central bankers and the left-of-center governments that are in power in most countries. The angriest battles have been in Germany, where Finance Minister Oskar Lafontaine has waged a relentless public campaign to persuade the Bundesbank and the European Central Bank to lower rates.

    In announcing the decision, Hans Tietmeyer, the president of the Bundesbank, said Thursday that the central bankers had acted in response to mounting evidence that European growth rates will be significantly slower next year than they had predicted as recently as last summer.

    "Our basic estimation is that there will be a measurable slowdown, but there won't be a recession," he told reporters. But he adamantly denied accusations that the decision was a response to political pressure.

    "We are deaf to political pressure, but we are not blind to facts and arguments," Tietmeyer said.

    Lafontaine, preparing to board a plane for the United States, said quickly on Thursday that he was pleased. "Over all, I'm satisfied," he said. "We saw how the crises in Asia were not without impact. On that basis we welcome this step."

    Most economists argued Thursday that the central bankers had strong reasons for opening the monetary spigots a bit. Even though Germany reported Thursday that its economic growth accelerated in the third quarter, government and industry economists have been lowering their projections for next year.

    Meanwhile, Europe's already low inflation rate has declined even further in the last year. In Germany, where annual inflation has dropped to seven-tenths of a percent from 1.8 percent so far this year, many experts say the country is already on the brink of at least a mild deflation.

    "I think it's a brave decision," said Kermit L. Schoenholtz, global economist at Salomon Smith Barney in London. "There are many who feared that the extensive criticism from political policymakers would prevent the European Central Bank from taking action because they would be worried about being seen as responding to political pressure.

    "What this showed is that they realized that they were brave enough to realize that their credibility is not enhanced by making bad decisions."

    Economists across Europe have lowered their predictions for growth in the euro zone to less than 2.5 percent in 1999 from about 3 percent in 1998. With inflation having all but evaporated, economists said the central bankers had room to inject extra money without causing prices to skyrocket.

    "If you look over the last 12 months, inflation has dropped substantially and interest rates have not," Fahrinkrug said. "The European Central Bank has demonstrated that it is sensitive to global woes and that it is ahead of the curve."

    But at least a few experts suspected that politics played at least an indirect role in the rate cuts. Skeptics noted that political leaders and central bankers had in some ways been shadow-boxing around a trade-off between lower interest rates and adherence to tough-minded budget policies.

    Lafontaine's top economic adviser stunned many economists last month by publicly arguing that European countries might have to relax the tough rules governing budget deficits for countries adopting the euro. Other leaders have suggested that governments might have no choice but to increase spending if the central bank refused to lower interest rates.

    "I think it was kind of a poker game between the governments and the central bankers," said Emmanuel Ferry, economist at Credit Commercial de France in Paris. "I think there was some very tough bargaining going on between the governments and the central bankers and that there was a trade-off between monetary policy and fiscal policy."

    But Ferry said he was as surprised as everyone else that the bankers moved as early as they did.

    "The timing is a big surprise because personally I was anticipating a cut during the first quarter of next year," he said. "Our idea was that the first move would be carried out by the European Central Bank."

    In effect, the decision announced on Thursday appears to have been made on Tuesday, when the central bankers from each country met in Frankfurt for a regular meeting of the governing council of the European Central Bank.

    Wim Duisenberg, president of the European Central Bank, dropped strong hints that a rate cut might be imminent after the council meeting broke up Tuesday evening. But the European Central Bank does not officially make monetary policy until January because the power remains with the national central banks until then.

    Tietmeyer, on the other hand, could not officially commit the Bundesbank to a rate cut without bringing the issue to a vote by his bank's board. As a result, the decision had to wait until Thursday, when the Bundesbank met for its regular meeting.

    World financial markets reacted modestly to the unexpected rate cuts. The dollar, which has increased significantly against European currencies in the last several weeks, held steady Thursday and traded for about 1.67 marks. Ordinarily, a surprise rate cut across Europe would tend to strengthen the dollar, but traders said the rate cut was offset by new worries about financial instability in Brazil.

    European stock exchanges all climbed slightly Thursday, in contrast to the declines suffered on Wall Street. Germany's DAX index of leading stocks climbed 2.13 percent, while the French CAC 40 index climbed 1.8 percent.

    The decision will probably reduce the political pressure on Duisenberg, the former Dutch central banker who has been fixated on demonstrating his political independence ever since European political leaders named him president of the new European bank in May.

    It was Duisenberg who remarked just one month ago that it was "normal" for politicians to voice their thoughts about monetary policy but that it would be "abnormal if those suggestions were listened to."

    Because the rate cuts were led by Tietmeyer, an undisputed monetary hardliner who has stared down political leaders time and again, they will almost certainly provoke less second-guessing than if they had been pushed through by the still-untested Duisenberg.

    "I think it was a pretty smart move to do it earlier, because it takes political pressure off the European Central Bank," Fahrinkrug said.

    But perhaps the most profound aspect of the rate cut was what it said about European monetary union. Under a single currency, every country becomes subject to the same monetary policy and interest rates essentially converge at some common level.

    That process of convergence has already been under way for a long time as central banks from Spain to Portugal to France modeled their policy after that of the Bundesbank. But the convergence reached its finale Thursday, when countries like Ireland and Portugal cut their rates by more than a half-point and brought them even with the low bar set by Germany. The 11 countries launching the euro are Austria, Belgium, Ireland, Italy, Finland, France, Germany, Luxembourg, the Netherlands, Spain and Portugal.

    Italy is now the only country in the euro zone with a base interest rate that is higher than 3.0 percent. But Italy cut its rates, too, and is expected to match those of its neighbors before Jan. 1.

    "What's important for investors and the financial markets is that Europe is stepping in with this interest rate, which is valid not just for one day," Tietmeyer said.

    Economists and bankers disagreed about whether Europe would have to lower rates even more in the months ahead. European rates are already about a full percentage point below the United States Federal funds rate.

    "The 3 percent level could hold for a significantly long time," said Matti Vanhala, governor of the Bank of Finland, at a news conference in Helsinki.

    But private economists like Ferry at Credit Commercial predicted that Duisenberg would have to reduce rates to about 2.5 percent by the middle of next year.

    "Financial markets are still nervous," said Werner Becker, an economist at Deutsche Bank Research in Frankfurt. "The central banks are beginning to recognize that inflation is no longer a problem and that deflation might be the bigger problem."

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