The Euro Zone: Inflation Paralyzes the ECB

The European Central Bank is in a bind: The latest data suggest that the impact of the global slowdown on the euro zone is intensifying, even as inflation continues to pick up. The ECB, limited by its commitment to price stability, can only wait for an opportunity to cut rates. And that may not come until summer.

Business confidence across the single-currency area is weakening, most recently in Belgium and the Netherlands, and most significantly in Germany, where it hit a 20-month low in March. France is a bright spot. Domestic demand there is buoyed by tax cuts and improving job markets, similar to the growth story in Italy. But weaker exports are slowing growth in both countries.

Most important, the German government recently sliced its 2001 growth projection, from 2 3/4% to 2%. The final rate may be even lower. Retail sales this year have been disappointing, suggesting that the lift from recent tax cuts has been less than hoped for. In addition, wages are failing to keep up with inflation, another drag on German consumer spending. And capital spending is slowing as global business investment, especially in the U.S., sags.

The ECB's dilemma is that rising inflation prevents the bank from cutting interest rates to spur growth. Moreover, the higher inflation is contributing to sluggishness in domestic demand, since higher prices rob households of purchasing power. Inflation readings from Germany, Italy, and Belgium hint that euro zone inflation in April could jump to near 3%, from 2.6% in March, a percentage point above the ECB's 0% to 2% target range. Euro zone inflation has been above the ECB's range for 11 months (chart).

The main inflation pressure stems from temporary runups in energy and food, the latter the result of the foot-and-mouth scare. However, core inflation is also rising close to the 2% ceiling. Both overall and core inflation are expected to peak this summer, at which time the ECB will feel comfortable in joining the rate-cutting policies of the rest of the world.

By James C. Cooper & Kathleen Madigan

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