Inflation: Europe's Untamable Dragon

The causes of the scare are beyond the ECB's control

In Germany, motorists cringe at every visit to the gas pump, as the cost of filling up a Mercedes luxury S-class auto has climbed in the past year from $55 to $85. In Ireland, where inflation is rising faster than anywhere in Western Europe, railway workers are on strike, demanding a 20% pay raise. Across the euro zone, manufacturers are reeling in the face of a 10% increase in the cost of imported commodities over the past 12 months.

Inflation and all its attendant ills are again a hot political issue in Europe. So it's time for the inflation police at the European Central Bank to ride to the rescue. But ECB President Wim Duisenberg and his partners will be faced with a formidable problem when they meet on Aug. 31: Nothing they do seems to have any impact on rising prices. Despite four rate hikes since February, the rate of inflation for the 11-nation euro zone is way beyond the monetary policymakers' 2% limit. The annualized figure was a worrying 2.4% in June and the same in July.

IDLE MOVE. As if that's not bad enough, the gap between inflation in the countries of core Europe, such as Germany and France, and those on the economic periphery, including Ireland and Spain, is growing ever wider. Irish prices grew almost three times as fast as Germany's in the year that ended in July.

What should the ECB do? The betting is that either at this meeting or the next it will again raise interest rates, by at least 25 basis points, to try to push inflation back down to acceptable levels. That will raise its key refinancing rate to 4.50%.

But the likelihood is that the move will again be ineffective. The reason, analysts say, is that the causes of Europe's inflation scare are beyond the ECB's control. Price rises have either been "imported" along with commodities like oil, or can be traced to the weak buying power of the euro--the common currency that has stubbornly refused to rally despite the ECB's best efforts. The sickliness of the single currency has added an estimated 0.6% to 0.8% to the euro zone's index of consumer prices this year.

As a result, the euro price of just about everything imported has soared. American soy products are 11% more expensive, while City of London business consultants are charging euro zone corporate clients on average 13% more for their services. The result for import-dependent companies such as Spanish retailer Galerias Preciados and Dutch charter airline Martinair is a higher cost base and growing pressure on margins.

Meanwhile, oil prices have surged by 50% since the beginning of 1999 to more than $32 a barrel. That has sent the cost of gasoline skyrocketing--to more than $1.05 a liter in France--and triggered a steep rise in manufacturing costs. BASF Corp., the German chemicals and pharmaceuticals giant, complains that rising energy and raw material prices will hit its profits in the second half of this year. Although sales are expected to increase strongly, earnings will grow little. Niki Lauda, the chief executive of Vienna-headquartered Lauda Air, says that rising costs mean he can't afford to meet employee union demands that he match the pay hikes and working conditions of Austrian Airlines.

STAGNANT PROFITS. The inflation demon once again confronts policymakers with a global economy that breaks all the rules. Conventional monetary wisdom says that even imported inflation should work its way through the economy as a whole. Companies pass on to consumers increases in the prices of raw materials. Workers then demand higher wages so that their living standards aren't eroded. Before you know it, inflationary expectations take hold, and prices start escalating. The classic central banker response is to jack up rates.

None of these traditional economic tenets, however, seem to be working in Europe. To begin with, higher oil prices don't seem to be producing the widespread price inflation in goods and services that usually occurs. One main reason: Soaring energy costs mean consumers have less to spend on other items. Another: Competition in many sectors of the euro zone is so sharp that companies can't afford to raise prices. That's why economists expect corporate profitability--which rose a strong 20% in the first half--to stagnate the rest of the year.

Unions, fearing that the ECB would retaliate with big, growth-curbing interest rate hikes if they push for significant wage increases, are also by and large being conciliatory. The Irish railway workers' stiff demands are an anomaly. The bulk of the wage settlements concluded in euro zone countries this year have been modest--in the range of 3%.

Such moderation is good news, of course. But it deepens the dilemma of the ECB: It's far harder to justify interest rate increases when wage rises are under control, and there is little evidence that imported price rises are about to ignite an inflationary spiral. Yet for the sake of its own credibility, the ECB can't be seen to do nothing.

On the monetary front, higher interest rates aren't likely to strengthen the euro, however much the ECB would like them to. The currency markets have already taken a 25-basis-point rate increase into account. Yet there is no sign of the euro recovering. It is still bumbling along just above its historic low of 88.44 cents. Growth in Europe still is not as strong as in the U.S. Moreover, U.S. interest rates are 2 percentage points higher than they are in Europe.

So it's very unlikely that the cost of imports will fall if the ECB does move as expected. Quite the opposite. Raising rates might simply increase the risk of an economic slowdown, which could frighten off investors rather than attract them. That could cause the euro to weaken further, driving the price of imports even higher.

Inflation: Europe's Untamable Dragon (int'l edition)

The policymakers at the ECB see they are backed into a corner. That's why most observers don't think they will try to crush the inflationary trend with a huge 50-basis-point increase that would really bruise the economy. Besides, the central bankers know in their hearts, like most clearheaded European analysts, that the best way to curb euro zone inflation is for national governments to deregulate markets more aggressively and forge ahead with much-needed structural reforms. But that's a lot tougher than gathering some central bankers in a room to tighten monetary policy.