Inflation's Shadow Dims Europe's Hopes

Rising prices are jeopardizing a recovery, as the European Central Bank may be forced to hike rates -- despite the howls

By David Fairlamb

The euro zone's economic recovery has only just begun to blossom, and already inflation poses a threat. Prices rose at a year-on-year rate of 2.4% in April, a hefty 0.2 percentage points above expectations. That means inflation in 2002 will likely exceed the 2% ceiling that the European Central Bank says is consistent with maintaining price stability. Monetary policymakers are getting nervous.

"There's now a risk the ECB will raise interest rates when its governing council meets on June 6," says Robert Prior, an economist at HSBC, the London-headquartered bank. "That could really hurt the recovery."

Most economists and the ECB had expected inflation -- which remained stubbornly above 2% throughout 2001 -- to fall quickly this year. But the high price of oil coupled with the weak euro means higher prices are being imported into the euro zone. A barrel of North Sea Brent crude now costs from $25 to $27, well above the $22 to $24 range most pundits were forecasting for this stage in the economic cycle.


  Statisticians at Eurostat, which gathers data for the European Union, say higher-than-expected energy prices account for around half of the inflation rate. Says Carlo Monticelli, co-head of euro-zone economics at Deutsche Bank in London: "We didn't think the price of oil would be up at these levels."

Bad weather, which has made fruit and vegetables more expensive, and tobacco-tax increases have also taken their toll. So has the introduction of euro notes and coins, which made prices rise by 0.16% as shops and businesses seized the opportunity to round up.

The big hope now is that prices will fall in May and trend down for the rest of the year. But that could be wishful thinking. For one thing, wages are rising faster than most analysts predicted. The German metalworkers have just won a 4% increase for this year and a 3.1% rise for next, after mounting the first major strike in seven years.


 Economists on the Continent now forecast that the euro zone's total wage bill will rise by around 3.5% this year. That wouldn't be so bad if productivity were surging at the same time. But it isn't. Labor productivity continues to disappoint, so wage hikes will probably be passed straight on to consumers in the form of higher prices. Meanwhile, several governments are likely to spend more heavily than planned this year and next, which will push more money into the economy and also help to nudge up prices.

To make things worse, core inflation -- which excludes energy and food prices -- also rose by 2.4% in April. Economists say the fact that this more fundamental measure is rising at the same rate as overall inflation will make it much harder for policymakers to beat down price rises.

The high core inflation figure shows that business is now passing on higher energy prices rather than taking a hit to profits. So it will take months before inflation starts to fall -- even if energy prices come down.


  Says ECB President Wim Duisenberg: "The inflationary outlook is now less favorable than it was at the end of 2001." ECB Chief Economist Otmar Issing says he's "increasingly coming to the view" that inflation won't fall below 2% this year.

Such comments are interpreted by Central Bank watchers as signals that the ECB is laying the groundwork for a rate rise in early June, from the current 3.25% to 3.5%. That could happen even if the U.S. Federal Reserve Board decides to hold its rates steady next month.

ECB officials stress that their prime responsibility as laid down in the Maastricht Treaty is to maintain price stability. Given that, they could well push rates up even if doing so would take some of the steam out of the economy.


  That prospect doesn't please European CEOs or politicians, who are calling on the ECB to hold rates down. It has also reopened the debate about the validity of the ECB's definition of price stability. Many executives and politicians believe that the 2% ceiling is far too stringent and that the ECB should set a higher trigger -- perhaps 2.5% or 3%. Such a shift would mean the bank needn't push rates up yet.

ECB policymakers aren't likely to heed the calls, however. "To move the goalposts now could hurt our credibility in the markets," says an official. "We're a young central bank, and we need to show that we don't change the rules when the going gets tough." Another big test for the new bank may be just ahead.

Frankfurt Correspondent Fairlamb covers markets and monetary policy in Europe for BusinessWeek

Edited by Douglas Harbrecht