ECB faces treacherous path over rocky US downturn

Today's meeting of the European Central Bank's (ECB) governing council ought to be a happier event than usual.

For one thing, it will be held by teleconference, so the 12 governors of the euro zone's national central banks will be spared their fortnightly trip to the Eurotower in Frankfurt.

With a series of wage negotiations looming in Germany, the ECB is unlikely to make any move on interest rates today, so the meeting's agenda will be relatively short.

The main source of new year cheer for the central bankers will be the euro's remarkable recovery on the foreign exchange markets. As market watchers predict the euro will return to parity with the dollar within weeks rather than months, Mr Wim Duisenberg and his colleagues are increasingly confident that the currency has at last turned the corner.

A stronger euro would boost confidence in the ECB as an institution and help it to fulfil its primary objective of keeping inflation down. But a sharp rise in the currency's value could create problems of its own and force the figures at the top of the ECB to take action on interest rates that would go against their ideological grain.

Mr Duisenberg has long believed the euro was bound to recover once economic growth rates in the US and the euro zone began to converge. As the US economy slows down, the ECB believes that the European economy is in for a period of sustained, non-inflationary, economic growth.

In common with some independent economists, the central bankers maintain that the creation of Europe's single currency has helped to immunise the euro-zone economy against the worst effects of a sharp downturn in the US. According to this theory, the old cliche that when America sneezes, Europe catches a cold no longer holds true.

More than 80 per cent of euro-zone exports are traded between member-states and the European economy is in better shape today than it has been for many years.

There are clear signs, however, that economic growth is slowing down, especially in the euro zone's biggest economies - France and Germany. Figures released this week showed that manufacturing activity in the euro zone fell in December to its lowest pace in 18 months. Two of Germany's leading economic institutes yesterday revised downwards their predictions for economic growth this year.

The Berlin-based DIW and the Ifo Institute in Munich both now believe that the German economy will grow by just 2.5 per cent this year - half a percentage point less than they were predicting a few months ago.

Although the ECB predicts growth of 3 per cent in the euro zone as a whole, many independent economists say that 2.5 per cent is a more realistic expectation.

A sharp rise in the value of the euro would hit European exporters at a time when demand in the US was likely to fall. The analysts at DIW believe the only hope of sustaining robust growth in the face of a slump in exports is to boost domestic demand.

Falling unemployment and ambitious tax reforms in Germany and France are expected to boost consumer spending this year but, if growth slows substantially, the ECB will come under pressure to cut interest rates.

Such a move may have been made more difficult by the embarrassing events of last year that prompted Mr Duisenberg to admit that he had unwisely blurted out details of the ECB's strategy for intervening in the financial markets. As the ECB president's standing has taken a knock, the position of the bank's chief economist, Prof Otmar Issing, has strengthened.

Widely regarded as the most formidable figure in the ECB's five-person executive, Prof Issing has benefited from the fact that the Bundesbank president, Mr Ernst Welteke, lacks the expertise of many of his predecessors. A deeply hawkish advocate of "sound money", Prof Issing is likely to resist any easing of monetary policy unless he is certain that there is no risk of inflation.

So Mr Duisenberg, having survived the turmoil of the euro's difficult birth, may now face an even bigger challenge - that of maintaining a strong currency without wrecking the economy it exists to serve. With elections due next year in a number of euro-zone countries, including France and Germany, Europe's politicians are depending on him to succeed.