Jean-Claude Trichet’s struggle to unite the European Central Bank’s Governing Council is being complicated by conflicting signals from the economy. As the 22-member council splits on whether it should buy financial assets to tackle the worst recession since World War II, reports are highlighting both the risk of deflation and the prospect of recovery. Economic confidence rose in April after 11 months of declines just as households anticipate that consumer prices will fall for the first time since at least 1990. With few signs of consensus evident, President Trichet will probably have to look for limited common ground at the ECB council’s meeting on May 7. That may see the ECB setting a floor to its key interest rate and extending the maturity of loans to banks while leaving open the question of asset purchases. “The mixed data is exacerbating the split,” said Laurent Bilke, a former ECB forecaster who now works for Nomura International in London. “At the same time they are under pressure to announce something, so it may boil down to the lowest common denominator.” Bilke, along with 45 other economists in a Bloomberg News survey, says the ECB will cut its key rate by a quarter point to a record low of 1 percent this week. The survey also shows the ECB will probably keep it there until the third quarter of 2010. The debate on whether the ECB should follow the Federal Reserve and the Bank of England in buying assets has splintered the council into at least three different camps, forcing Trichet to impose a vow of silence on officials. Soap Opera “ECB commentary has been a soap opera over the last few weeks,” said Tim Foster, who manages about $9 billion of funds at Fidelity Investment Management in London. In one corner, Germany’s Axel Weber says that buying assets should only be a last resort and the ECB should keep its focus on greasing the banking system with loans. He also warns that cutting the main rate below 1 percent may disrupt money markets. In another camp, Greece’s George Provopoulos and Cyprus’s Athanasios Orphanides want to keep open the option of deeper rate reductions and asset purchases to combat deflation risks. Separately, Austria’s Ewald Nowotny argues that asset purchases are “sensible,” while agreeing with Weber on a 1 percent floor for the main rate. Mixed Data Recent reports give ammunition to all sides of the argument. The European Commission said confidence in the economic outlook increased last month. Manufacturing and services industries shrank at the slowest pace in six months and Europe’s Dow Jones Stoxx 600 Index rose 13 percent in April, erasing its loss for the year. At the same time, lending to euro-region companies and consumers declined for a second straight month in March, and a European Commission survey shows households expect prices to fall over the next 12 months. Producer prices fell 3.1 percent in March from a year earlier, the biggest drop in 22 years, the European Union’s statistics office in Luxembourg said today. “None of these indicators actually point to a sustainable recovery and I fear that the ECB will look at these as an excuse not to be as aggressive as it should be,” said James Nixon, an economist at Societe Generale SA in London. Weber and colleagues such as Juergen Stark and Lorenzo Bini Smaghi say that the ECB should keep its focus on reviving interbank lending because almost three quarters of company financing comes from banks rather than capital markets. Deflation ‘Iceberg’ Bini Smaghi devoted much of a speech on April 28 to the difficulties associated with the ECB buying assets. Purchasing government bonds “poses some intricate challenges” due to the euro area’s institutional framework, he said. Buying corporate debt may also prove a “difficult endeavor,” Bini Smaghi said, noting the “limited depth of corporate bond markets in many countries.” One solution could be for the ECB to boost lending by purchasing newly-syndicated bank loans to companies, “which would fit in rightly with the ECB’s objective of keeping its policy bank-centered,” said Nomura’s Bilke. Julian Callow, chief European economist at Barclays Capital in London, says policy makers will have no choice but to eventually put aside their differences. “While on the upper deck of the ship the Governing Council debates the finer theological issues, the iceberg of deflation draws ever closer,” said Callow.

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