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Expectations for central bank stimulus grow in Europe; French PM resigns in feud over economy

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FRANKFURT - Worries about the economy are rippling through Europe.

Downbeat data have pushed the European Central Bank closer to more drastic action to keep the hesitant recovery from stalling completely.

Meanwhile, open feuding in the French government about how to break out of economic stagnation saw President Francois Hollande dissolve the cabinet and order Prime Minister Manuel Valls to form a new team.

Concerns had grown so strong that by Monday investors were willing to bet that the ECB will intervene with new stimulus measures, based on comments late Friday by bank President Mario Draghi. Stocks in Europe rallied.

Draghi warned that low inflation — a sign of economic weakness — could be getting worse. Draghi also underlined the sense of urgency by telling European governments to make a more co-ordinated effort to boost growth through tax cuts and a new joint investment program.

Predictions that more ECB help will be needed were reinforced Monday by a drop in Germany's closely-watched Ifo business confidence index. It fell to 106.3 points in August, from 108 in July and below analysts' expectations for a dip to 107.

The downbeat signal from the largest of the 18 economies that use the euro follows drops in other surveys of business activity. The currency union showed zero growth in the second quarter after four quarters of weak recovery from its crisis over government debt.

The recent data, coupled with turmoil in Ukraine and the Middle East, has shaken confidence in the ECB's outlook that modest growth will continue. The ECB launched a raft of measures in June, including a cut in its benchmark interest rate to a record low of 0.15 per cent and an offer of cheap loans to banks that are willing to lend to businesses. Officials have said they want to wait to see how those steps work.

But signs are growing that the ECB and its president, Mario Draghi, may not have that luxury.

"The continued fall of the Ifo is really problematic for the rest of the euro area, which is barely growing," said Commerzbank's chief economist, Joerg Kraemer. "The ECB's optimistic economic outlook is crumbling."

Draghi has said that if weak inflation — now only 0.4 per cent — shows signs of worsening, the bank could launch large-scale purchases of financial assets, known as quantitative easing, or QE. He said Friday at a conference in Jackson Hole, Wyoming, that inflation expectations have "exhibited significant declines at all horizons."

He said the bank would "acknowledge these developments" and use "all the available instruments" to keep prices stable.

Economist Kraemer said the comments mean that "the probability of broad-based bond purchases (QE) is rising." The ECB's governing council next meets Sept. 4.

Shares rallied on Monday on the prospect of more stimulus, with the benchmark German and French indexes up 1.8 per cent and 2.1 per cent. The euro fell to $1.3198 from $1.3242 late Friday — QE can send a currency lower. Tellingly, European government bonds rose, driving down their yields, which move opposite to price. Germany's 10-year bond yielded 0.93 per cent; the equivalent bond issued by Ireland, which needed to be bailed out in 2010, yielded 1.81 per cent, below even U.S. Treasurys at 2.39 per cent.

In quantitative easing, a central bank creates new money and uses it to buy financial assets such as bonds. That pumps newly created money into the financial system. It can in theory increase the amount banks can lend, push up the price of stocks and other assets, drive down interest rates, and increase inflation. The U.S. Federal Reserve, Bank of Japan and Bank of England have all used quantitative easing. But there are legal, political and practical hurdles to doing it in a multi-country currency union and so far the ECB has held off. QE can also push up stock prices, which may help explain why share prices rose after Draghi's remarks

Draghi also urged European governments to move past their recent focus on austerity and do more to boost growth with tax cuts — offset by spending cuts to remain within the strict European Union limits on government deficits. He called on them to push ahead with longer-term reforms such as better worker education and more flexible rules on hiring and firing. He also endorsed a plan to set up a 300 billion-euro program for public-private investment proposed by Jean-Claude Juncker, the incoming president of the EU's executive commission.

France's Socialist President Hollande has struggled to push through pro-growth measures. France, the No. 2 economy in the eurozone, has had no growth this year.

Hollande's promises to cut taxes and make it easier for businesses to open and operate have stalled, in large part because of the divisions among his Socialist party. Prime Minister Valls resigned after left-wing Economy Minister Arnaud Montebourg criticized austerity and called for "a major change in our economic policy."

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