Jean-Claude Trichet, president of the European Central Bank, appeared flustered after last week's meeting of the bank's governing board. Mr Trichet, in the job for more than a year, may have been tired having recently returned from a seminar in Rio de Janeiro. But the increasing gloom about the outlook for the eurozone economy - where he has responsibility for monetary policy - may also have weighed on his mind.

After a relatively strong first six months this year, growth in the 12-country eurozone has slowed sharply. Gross domestic product rose by just 0.3 per cent in the three months to September compared with the previous three months, as export growth slowed and household spending remained flat. The ECB has backed away from its earlier forecast of an acceleration in activity at the start of next year and on Thursday revised downwards its forecast for 2005, blaming the impact of higher oil prices on growth. Private sector economists have followed its example, reducing projections for growth in coming quarters - and adding the strength of the euro against the dollar to the list of the eurozone's economic woes.

On Monday, Joaquin Almunia, European monetary affairs commissioner, hinted that the European Commission would revise down its forecast, made in October, of 2 per cent growth next year. "We have become somewhat more worried as some of the downside risks that we presented then may be materialising," Mr Almunia said.

There is even talk of recession. Joachim Fels, economist at Morgan Stanley, expects growth of 0.2 per cent in the first three months of 2005. "I would argue that the eurozone is flirting with recession," he says. "I would put the chances of a short recession in the first half of next year at about 40 per cent." The ECB now expects growth of about 1.9 per cent next year, little better than in 2004.

While consumer spending seems to have staged a slight recovery in Germany and France, the eurozone's two largest economies, this quarter, other data point to slowing growth in output. In November, the purchasing managers' indices for eurozone manufacturing and service sectors - regarded as leading indicators of likely output trends - showed manufacturing growth slowing sharply, with services not far behind. If the indicators are correct, manufacturing output is already contracting in Germany and Italy.

For all their vaunted ambition to become the world's most competitive economy by 2010, the economies of the eurozone seem once again to be spluttering, left behind by the US, where third quarter growth was more than three times as fast.

The fact that the euro's status as a reserve currency is increasing is scant consolation. Oil exporting countries are the latest to reduce their holdings of a weakening dollar. The euro has risen 8 per cent against the dollar since the beginning of October. Politicians, especially from countries such as Italy, which is struggling to maintain international competitiveness, have become more strident in their demands that, if the US will not act to support the dollar, the ECB should take steps to curb the euro's strength. Eurozone finance ministers, who met in Brussels this week, said that "excessive volatility and disorderly movements in exchange rates are undesirable for economic growth".

But Mr Trichet has been at pains to point out that the ECB believes it has created conditions for growth. Real interest rates, taking account of inflation, are zero, creating easy financing conditions. World economic growth, exceptionally buoyant in 2004, is expected to continue growing at a reasonable pace next year, supporting exports.

So why is the outlook for the eurozone economy so gloomy? Higher oil prices are one reason and the euro's strength has, at the very least, acted as a brake on export growth. At the same time, eurozone economies have not enjoyed the fiscal stimulus seen in the US.

But there are more fundamental reasons behind the eurozone's malaise. Strong growth in exports has not fed through into domestic demand in the way that would have been expected from the experience of previous cycles. Capital spending has grown modestly but consumer spending has barely moved, rising by just 0.2 per cent in both the second and third quarters.

Michael Dicks, economist at Lehman Brothers, says that traditional economic models for forecasting consumer behaviour have broken down: they no longer explain why so much is being saved rather than spent. His explanation is that the eurozone - especially Germany - is suffering the short-term side effects of the push towards structural reforms by governments and restructuring by companies, both with the aim of boosting longer term labour flexibility and international competitiveness.

Mr Dicks warns that the increase in "precautionary savings" by eurozone consumers "might become a permanent phenomenon if the authorities are seen reneging on the social contract and no longer deliver the sort of services that people have come to expect from the welfare state". John Lipsky, chief economist at JP Morgan, argues that the "corporate adjustment process" was much more "brusque" in the US, and was largely completed by the end of 2002. "In the eurozone, the corporate adjustment has not yet been completed."

At the ECB, Mr Trichet's dilemma is twofold. First, his job is not, primarily, to boost growth in the eurozone or to help eurozone exporters. The mandate inherited from the Bundesbank, the German central bank on which the ECB is modelled, makes ensuring price stability its main task - although he can argue that price stability creates conditions for growth.

But, thanks largely to higher oil prices, "the short term outlook for inflation remains worrisome", Mr Trichet said last week. At 2.2 per cent in November, inflation is above the ECB's target of below but close to 2 per cent, and is unlikely to fall below the target level until well into next year.

Second, it is far from clear that the ECB's governing council would accept that the euro's strength is a significant factor in the eurozone's malaise and that therefore a cut in interest rates was justified.

Although Mr Trichet describes recent currency moves as "unwelcome" and "brutal", he has not offered any insight into how big a factor the ECB believes it is in slowing growth. However, Nicholas Garganas, Greece's representative on the council, last month told the Financial Times that "there is enough support for euro-area exports to more than compensate for the negative effects of the strong euro at present levels". Moreover, a strong euro helped "contain inflationary pressures at a time of rising energy costs". On a trade weighted basis, the euro has risen only about 2.5 per cent against the dollar since early October.

Otmar Issing, the ECB's chief economist, has also suggested that the impact of trade on the eurozone's growth performance might have been exaggerated (see below).

Mr Trichet has had his fingers burnt before when he has hinted at action that would boost the economy. In March, he indicated that interest rates would be cut if domestic consumption did not recover as expected. At the time, in the aftermath of the Madrid terrorist bombings, there were signs of the economy slowing - although in fact, it would prove to be the best quarter of the year.

In the event, the ECB held rates steady and Mr Trichet was accused by financial market analysts of sending confusing signals. There is a suspicion among some analysts that Mr Trichet was out-gunned by those against an interest rate cut on the governing board. Last week, he admitted that the governing council had even considered raising rates at its latest meeting.

Another factor influencing the ECB is the sharp growth in money supply. Unlike other central banks, the ECB uses monetary aggregates as an important indicator of likely inflation trends, emphasising that inflation is a monetary phenomenon over the medium to long term. M3, a broad measure of money supply, has been rising at an annual rate of about 6 per cent

Thorsten Polleit, economist at Barclays Capital in Frankfurt, admits the monetarist argument -watching the money supply figures -"is often more an ideological battle, not always a scientific debate". But he sees evidence of asset price rises in the eurozone economy that should worry the ECB, for instance the rise in house prices in France and Spain, encouraged by the low cost of mortgage borrowing.

In the same context, Mr Fels at Morgan Stanley also points to the rise in equity markets. Germany's Dax 30 index is brushing new highs "just at a time when everyone is revising downwards their macroeconomic forecasts".

Mr Fels argues that the eurozone faces the risk of "stagflation" - the combination of stagnant economic growth and rising inflation - not in the conventional sense of consumer price inflation, but the inflation of asset prices. The fear of creating asset bubbles that burst with damaging consequences - such as Japan's after the expansionary monetary policy of the late 1980s - would make the ECB loathe to cut interest rates.

But it seems just as unlikely that the ECB would raise rates through fear of sending the euro higher against the dollar. One option would be for the ECB to use financial intervention if the euro were to suddenly jump again against the dollar. A Japanese finance ministry official said last week that the Japanese and eurozone monetary authorities had discussed joint currency market intervention. But there are at least a few members of the central bank's governing council who would argue that intervention is rarely, if ever, effective.

That leaves the eurozone economy dependent on itself and its political leaders to gather steam. The ECB seems confident that will happen.Axel Weber, Bundesbank president, this week said he saw "the first gleam of hope regarding the investment dynamic, especially for capital investments". Many economists believe that growth will gradually pick up, particularly as the wave of corporate restructuring moves on from producing only short term disadvantages such as depressed consumer confidence.

Mr Lipsky at JP Morgan detects a mood change among Europeans - "a growing sense of frustration that the eurozone economy could and should be doing better". The EU's expansion this year to include 10 new members, many of which are keen to join the eurozone, "has had a psychological effect and signaled the need for structural improvements", Mr Lipsky says. If the effects could feed through soon, it would make Mr Trichet's work easier.

Issing keeps the focus on price stability

On foggy winter days in Frankfurt, Otmar Issing, the European Central Bank’s chief economist, likes to point visitors to the view from his office near the top of the ECB’ s Eurotower, writeRalph Atkins and Mark Schieritz. Peering into the mist is a bit like his job, he jokes.

The economics professor from northern Bavaria joined the ECB’s executive board in 1998 with a reputation as an inflation “hawk” earned from his eight years on the board of the Bundesbank, Germany’s revered central bank.

In an interview with the Financial Times, Mr Issing admits that third-quarter gross domestic product growth in the eurozone was “disappointing” and that it is “still not so easy to give a convincing interpretation” of the data.

“I think that there are strong indications that the decline in the third quarter was of a one-off, temporary nature. We can assume that growth rates will pick up again and will come back to levels roughly in line with potential,” Mr Issing says.

The ECB’s assessment of the eurozone’s potential growth rate - the speed at which it can grow without adding to inflationary pressures -was 2-2.5 per cent, but Mr Issing says: “After years of weak investment, we will now be closer to the lower point than the upper point in the range.”

Mr Issing adds: “What is different in our staff’s latest projections [released last week] is that the stronger acceleration that we had initially expected in 2005 probably will not materialise.

“But the positive message is that we will have a continuation of this moderate growth.”

How does he explain the eurozone’s weakness compared with the US? Mr Issing says that about one percentage point of the difference is due to increases in the US labour supply. For the remainder, he says, the consensus is that the causes are structural.

Mr Issing says the discussion on economic reform “has progressed furthest in Germany”, with a “broadly-based” awareness on the need for change that has not emerged in all European countries.

He insists that the eurozone’s one-size-fits-all monetary policy - which imposes the same interest rates on all 12 members - cannot be blamed for its poor economic performance.

Mr Issing also argues that the ECB - which has left its principal interest rate unchanged for 18 months - has acted efficiently and in the eurozone’s best interests. There was criticism prior to the establishment of the central bank in 1998 that the national bank governors on the ECB’s governing council would squabble and promote their national interests.

But Mr Issing says: “In six years of conducting policy there has not been one case in which a member of the governing council has gone public with a criticism of our monetary policy . . . The fact that we have not changed interest rates since June last year is certainly not an indication that we tried unsuccessfully to find a compromise. Quite the opposite. Consensus does not imply slowness in decision making.”

Mr Issing stresses the importance the ECB attaches to the outlook for prices, at a time when oil prices are fuelling inflation. “We are, as we have been in the past, in a critical situation when it comes to guiding inflation expectations. This is key. Our credibility in maintaining price stability must not be put at stake,” he says. “We have seen some signs of concern in markets: in the context of higher oil prices you see inflation expectations deteriorating somewhat. So it is crucial that, looking beyond this direct impact, markets and people expect price stability to be restored.”

On the euro’s rise against the dollar, Mr Issing repeats the ECB line that recent exchange rates moves are “unwelcome” and “brutal”.He suggests, however, that economists may have worried too much about the apparent failure of strong export growth to feed through into the eurozone’s domestic economy.”It seems to me that there is a misperception of what was driving growth and the recovery in the euro area. It was not net trade. The contribution of net trade [growth of exports minus imports] was negative in 2003 . . . In 2004 it will be about zero and in our projections it is expected to be roughly zero in 2005 and 2006.”

The ECB is forecasting a “gradual recovery” in eurozone growth over the next two years. Mr Issing expects private consumption to pick up in line with real disposable incomes. Unemployment has stabilised and wages have increased moderately, he says. “This is all very modest but we would expect that the labour market would improve slowly. Our projections are based on this kind of scenario - not something spectacular.”