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Fresh Signs of Euro Zone Economic Weakness

Analysts say ECB likely to cut interest rates by 50 basis points next month but doubt that would be enough to halt slide.

The euro zone economy has suffered its worst quarter in three years, according to a prestigious survey of purchasing managers that has hardened convictions that the European Central Bank (ECB) will cut rates at its July meeting.

Thursday’s monthly index of purchasing managers published by Markit Economics showed another sharp decline in activity in June, after dismal surveys in April and May. Taken together, these persistently gloomy reports suggest the private sector shrank in the second quarter at its fastest pace since 2009.

The downbeat tone of the June survey reflects recent weakness in Germany — which earlier in the year had acted as a bulwark against economic catastrophe in the euro zone — as well as a poor performance in peripheral member states whose economies are crippled by sovereign debt crises.

“The downturn is gathering pace and spreading across the region,” said Chris Williamson, chief economist at Markit.

The survey has strengthened the belief among many economists that the ECB will cut its benchmark interest rate from 1 percent at its next meeting. Stella Wang, European economist at Nomura, said the survey made Nomura “comfortable” with its preexisting prediction of a 50 basis point (bp) rate cut on July 5.

According to Williamson, “The near-record deterioration in business optimism, combined with marked falls in employment and purchasing by companies” in the provisional June survey for the euro zone “suggests that firms are preparing for conditions to worsen in the coming months.” They are responding to “uncertainty caused by the region’s ongoing economic and political crises.”

But amid the dismal data were a couple of shards of light.

One was the continued strong employment performance of Germany. On the bad side, the overall German index fell from 49.3 to 48.5 — with any figure below 50 suggesting a contraction in output. The euro zone index was unchanged at 46.0 — signifying a continued slide in activity. However, the data suggested that German employment increased in June — providing support to consumer demand in the euro zone’s largest economy.

German employment has repeatedly risen to record highs in recent months despite the currency union’s troubles. Analysts attribute this largely to reforms in recent years that have progressively increased incentives to work by making welfare less generous and to the acceptance by unions of flexible working patterns, which has allowed companies to expand employment by keeping a lid on unit labor costs.

Economists hope that Germany’s strong labor market will play a role in rebalancing the global economy — allowing domestic demand to rise to take up the slack caused by underlying weak demand in other countries such as the U.S. and Britain that are burdened by high household debt.

Another bright spot in the euro zone survey was the easing of input price inflation, which fell to its weakest level since late 2009 because of lower raw material costs. Brent crude oil dropped to an 18-month low below $91 a barrel on Thursday, changing hands at $90.60 in U.S. lunchtime trading.

Economists hope that lower prices for oil and other commodities will give the ECB a free hand to cut rates at its next monetary policy meeting in July. Euro zone inflation declined to 2.4 percent in May from 2.7 percent in March according to preliminary estimates, and the ECB expects it to fall below 2 percent — the upper limit of the central bank’s target — early next year.

However, many economists are skeptical that even a 50 bp rate cut — which would halve the ECB’s benchmark rate — would prove very effective.

On the one hand, a slashing of the benchmark rate to 0.5 percent could boost demand for loans from companies and households — stimulating economic activity. It would also probably make euro zone manufacturers more competitive by reducing the value of the euro. A 50 bp reduction in the benchmark rate would bring it into line with the Bank of England’s repo rate of 0.5 percent and near to the Federal Reserve’s target rate of between zero and 0.25 percent. This would reduce the euro’s value, by taking an ax to the interest-rate incentive for holding euros.

On the other hand, business and consumer confidence is low in the euro zone — setting a limit to likely investment even under an ultra-low interest rate regime.

Many economists are pinning less hope on a rate cut by the ECB and more on support by euro grandees such as Italian premier Mario Monti for massive buying of peripheral euro zone bonds by the European Financial Stability Facility — the currency union’s rescue fund. Advocates say this could boost the real economy by restoring confidence in the public finances of Spain and Italy — though Angela Merkel, who as Germany’s chancellor holds the EU’s purse strings, has not yet consented to open this particular purse.

Many private-sector economists continue to berate politicians and central bankers in the currency union and elsewhere for not taking sufficiently radical measures to boost flagging economies. “Today everyone would love more growth, and less austerity, to tackle the debt burden, but few seem to know how to achieve it,” HSBC economists said in their quarterly global review, published Thursday. They added, “Western policymakers — be it governments or central banks — are seemingly paralyzed, unsure what to try next.”

The euro had slid 1 percent against the dollar to $1.257 by U.S. lunchtime trading, as investors digested the poor purchasing manager numbers and the increased likelihood of a rate cut.

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