Fear Of Inflation Is Roiling The Markets

Across Europe, business is finally picking up after the Continent's worst recession in decades. Inflation is falling, and labor markets are slack. On the political front, the European Parliament vote on June 12 gave German Chancellor Helmut Kohl's reelection bid a shot in the arm and broadly boosted conservatives in general.

So how are Europe's markets taking the good news? Even before recovery gets rolling, traders are hammering stocks and spiking bond yields up to levels they haven't seen for nearly a year and a half. The traders' great fear is that inflation hasn't been tamed and that it will come roaring back. There are now even questions about the motives of Europe's top inflation-fighter, Hans Tietmeyer, president of Germany's Bundesbank.

What's so dangerous is that investors are sounding the inflation alarm so early in Europe's recovery. The inflation scare could well set the stage for a bond-market version of last summer's exchange rate turmoil. Some market watchers now think that the Bundesbank might even have to resort to increases in interest rates this year to overcome the inflation worries dogging the markets. If so, it would send a chill through business

recovery plans. Many European companies are just starting to feel the benefits of the decline in short-term rates that began two years ago.

RIGID RULES. In the U.S., the rebound was well along before such fears surfaced. The early worry in Europe arises from the unexpected strength of the recovery and from French and German politicians--concerned about major elections--raising growth expectations even higher. For example, Michael R. Rosenberg, manager of international fixed-income research at Merrill Lynch & Co., thinks the European economy will be booming again as early as next year, with Germany registering close to 3% growth and France 3.4%.

But while inflation is less than 2% in France and below 3% in Germany now, investors fear that even modest growth will fire up higher prices. That's because Europe's labor markets are much less flexible than those in the U.S. As a result, recovery could quickly lead to fat wage settlements.

There's a showdown looming between central bankers and politicians. The central bankers are increasingly targeting governments that show no signs of cutting spending and that are not taking steps to make their workforces more competitive. In its annual report issued on June 13, the Bank for International Settlements warned that unless European governments move to lower minimum wages and loosen work rules, recovery may not reduce jobless rolls. The BIS argued that Europe's rigid work rules could cause inflation to reappear at a much higher rate of unemployment than in previous economic cycles.

The tension is spreading to governments and business alike. With German bond yields hovering near a 17-month high (chart), Germany in early June canceled its second bond auction in a week. Spain also scrapped two auctions needed to fill budget gaps. In France, where Treasury officials based their budgets on yields averaging 5.5% this year, the rise in bond yields to nearly 7.5% is becoming another headache.

HELMUT HELPER? What would help calm the markets would be for investors to regain confidence in Tietmeyer's inflation-fighting abilities. Market confidence in the Buba was shaken in mid-May when Tietmeyer cut Germany's benchmark discount rate by 50 basis points, to 4.5%. With money-supply growth running at 15%, more than double the Buba's target, the deep cut raised questions about whether its primary intent was to help Kohl's electoral chances. Ever since, Buba officials have been scrambling to talk tough on further rate cuts. But Buba-watchers think that Tietmeyer, rather than having the flexibility to cut the discount rate down to 3.5% by early next year, may be forced to reverse course if traders' fears of inflation persist.

What's clear is that as long as the Bundesbank remains under a cloud and central bankers and politicians are feuding, even good economic and political news won't count for much. As in the U.S., once inflationary expectations get started, they're hard to stamp out. Unless Europe's leaders can take more convincing action to demonstrate that inflation is licked, the Continent could be in for another long, hot summer.

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