European Central Bank to ease interest rates?

The European Union flag appears through tree branches on Nov. 30, 2011, in Berlin.
Sean Gallup/Getty Images

FRANKFURT, Germany Evidence that Europe's economic downturn is affecting its strongest member, Germany, is convincing many experts that the European Central Bank will cut interest rates from the current record low.

After a survey showed a slowdown in German's key manufacturing sector, an index of business optimism also came in surprisingly weak. The Ifo index fell to 104.4 points in April from 106.7 in March, more than the modest dip foreseen by market analysts to 106.2.

The index remains at a high level, and the institute's survey chief, Kai Carstensen, said it only mean that "the German economy is taking a breather."

But outside analysts said the indicators cast enough doubt on hopes for recovery for the ECB's 23-member governing council to cut rates from the record low of 0.75 percent, either at its May 2 meeting or on June 6, when it will have new staff economic projections to help justify any decision. Traders prepared for such a move by buying heavily into European stocks in hopes of further stimulus. German's stock index is up 3 percent in two days, France's almost 4.5 percent.

The strength of the German economy is key to the ECB's rate decisions because of its size it accounts for 28 percent of the 17-country eurozone's total output. It shrank 0.6 percent in the last three months of 2012 and most economists expected it to grow this year, but those predictions have been shaken this week's weak indicators.

Germany has been one of the more resilient economies in the eurozone and a slowdown in its economy would make it harder for the region to climb out of recession. The eurozone shrank in the fourth quarter and the ECB has been expecting it to contract 0.5 percent for all of this year, with a gradual upturn near year end.

"Resistance to a rate cut will be crumbling," said Christian Schulz, an analyst at Berenberg Bank in London, after the Ifo survey was released.

Analysts at Swiss bank UBS have changed their forecasts and now predict an ECB rate cut on May 2. They had previously expected rates to remain unchanged through the end of next year. Royal Bank of Scotland analysts Richard Barwell and Xinying Chen also shifted their prediction to a cut to the May meeting.

They noted that ECB President Mario Draghi said in April that the bank remained "ready to act" in case the economic indicators worsened.

He has indicated that the ECB's governing council has discussed cutting rates at previous meetings a sign some members think it's time for one more cut. But the ECB has held off, in part because the bank's top officials, led by Draghi, argue that another cut would not help very much.

In a sign that support for a rate cut may be growing, the head of the German central bank, which has typically been more reluctant to back rate cuts, said last week that a cut could be warranted if economic indicators worsen. Since his comments, they have.

The ECB's key interest rate is what it charges to lend to banks. As a result, it influences a host of other rates that determine how much it costs businesses and consumers to borrow.

Low rates in theory encourage borrowing to spend and invest, stimulating the economy. But rates are already low, and top ECB members have argued that the cheap financing is simply not reaching many companies. That is because troubled banks in some parts of the eurozone are reluctant to lend.

Analysts say a rate cut might be mostly symbolic and do little to spur lending directly. It could, however, lower the euro's exchange rate, which would help exporters. Lower rates make interest-bearing investments in euros less attractive and reduce investor demand for the currency.

The ECB has also been looking at unspecified new way to help the economy that go beyond interest rates. Analysts say the ECB might take steps to try to increase bank's willingness to make loans to small and medium size businesses, which provide most of the eurozone's jobs. Ideas that have been floated include loan guarantees from another European Union agency, or permitting banks to bundle loans to small businesses as securities and use them as collateral to get cash loans from the ECB.