Europe in tough spot on rates

LONDON (CNNMoney.com) -- Just weeks after the Federal Reserve made a bold strike at the credit crisis, central bank chiefs in Europe are being put to the test.

Policymakers in Britain and Continental Europe, like their U.S. counterparts, must balance the threat of a sharp slowdown in economic growth against the risk of rising inflation. If they don't succeed, the global economy, already feeling the drag from the United States, could face more pressure.

Both the Bank of England and European Central Bank held rates steady on Thursday, as expected. That leaves U.K. rates at 5.75 percent and rates for most of Europe at 4 percent.

But since the Fed slashed its key short-term interest rate by half of a percentage point last month to prevent a U.S. recession, there are growing expectations for central bankers in Europe to eventually do the same.

The Fed's action doesn't directly affect policy elsewhere in the world. But other central bankers may have to follow suit now that credit problems that sprang up in the United States are having a significant effect on the economies across the Atlantic.

While turbulence in the global credit markets has eased, European banks are still far from functioning normally. Anxious banks, rocked by bad home loans given to U.S. borrowers with poor credit, are still clamping down on credit, and rates in the interbank market, known as Libor, remain elevated.

The Bank of England is expected to be the first to break out of the wait-and-see mold. Confidence in the nation's financial markets has been undermined by the near collapse of British bank Northern Rock.

"There is the risk the banking system reduces its lending over the coming months, which will start to filter its way through the economy," said Philip Shaw, chief economist at Investec Securities. He thinks the central bank could cut rates as early as November.

A survey released by the Bank of England last week showed that financial institutions expect to "significantly" reduce the amount of money they lend to businesses over the next three months.

The Organization for Economic Co-operation and Development recently warned the credit crunch could lower the U.K.'s economic growth rate next year to below the 2.5 percent it had projected before volatility rocked financial markets, as the housing market and financial services sector start to weaken.

"Although indicators of economic activity have been robust in 2007 to date, there is now a risk that growth will be weaker going forward, which could imply a need for interest rate reductions," it said.

Risks to the euro zone economy have also risen as the dollar has plunged against the euro. The euro rose to a record $1.4283 on Monday. The fear is that the strengthening currency could take its toll on European exports, which in turn could dampen economic growth.

"The euro zone economy is sliding down a slippery slope in terms of growth expectations," said David Brown, chief European economist at Bear Stearns. "Some parts of the euro zone economy may be flirting with recession."

Bear Stearns expects the euro area to grow 2.3 percent next year, but that could be revised to below 2 percent if the ECB doesn't start lowering rates, Brown said.

So far, inflation concerns have kept central bankers in a holding pattern. Inflation in the euro area jumped to 2.1 percent in September, according to initial estimates. That's up from 1.7 percent in August and above the ECB's preferred annual rate of 2 percent.

In the U.K., inflation fell to 1.8 percent in August, but there are worries that it also will flare up. With food prices soaring and oil around $80 a barrel, businesses may eventually pass on higher costs to consumers.

"I think inflation will remain contained, but there's enough underlying concern at the moment for the Bank of England to be reluctant to cut interest rates," said Howard Archer, chief U.K. economist at Global Insight.

Whether other central bankers follow in the footsteps of the Fed will depend largely on how badly their respective economies are stung by the credit turbulence.

"The Bank of England is reluctant to cut rates until they see the economy is slowing," Archer said. "They would need to see clear evidence that there's been a significant hit before cutting interest rates."

For sure, that picture will come into sharper focus with time. But if bank chiefs in Britain and Europe wait too long, the damage may already have been done by the time they're ready to act.