Inflation Raises Its Ugly Head in Europe

The ECB may have to hike rates, hurting the recovery

It weighs on Europe like a ball and chain. Despite optimistic forecasts, the 12 countries of the euro zone continue to have an inflation problem. Yes, preliminary calculations indicate that inflation fell to 2% in May, the first time in two years that it has hit the target set by the European Central Bank. But the Frankfurt-based bankers aren't celebrating. They dismiss the expected fall in the consumer price index--down from 2.4% in April--as largely the result of technical factors, and they predict that inflation will jump again in June. Disturbingly, inflation will continue to be highest in many of the countries along the euro zone's rim, but without the benefit of robust growth.

In bankspeak, the bankers are already sounding a warning. "The outlook [for price stability] is less satisfactory than expected a few months ago," warned ECB President Wim Duisenberg on June 6, shortly after the bank's governing council decided to leave its key interest rate unchanged at 3.25%. But many expect the bank to raise that rate in July or August.

Why a hike just when recovery is starting? Duisenberg's overriding concern is that inflation is becoming an entrenched feature of the euro-zone economy. In fact, the core inflation rate, which doesn't include volatile energy and fresh-food prices, is expected to be 2.4% in May, no drop at all from April.

Inflationary expectations certainly seem to be taking hold. Gwyn Hacche, an economist who tracks Europe for HSBC Investment Bank, says movements in bond prices show that euro-zone inflation will rise to 2.2% this year, well above the 1.5% they indicated last November. Most economists had assumed that inflation would fall quickly below the ECB's 2% ceiling in the first half of 2002, then stay there.

Meanwhile, European Commission surveys show that consumers' price expectations have climbed sharply in most euro-zone countries during the past year. In Germany, where the CPI is below 2%, consumers are convinced that prices are rising faster than that. "Just look at clothing or a meal out," says Julia Hagen, a Frankfurt teacher.

Such sentiments feed on themselves. Already, companies are seeing greater union militancy and higher-than-expected wage settlements. Germany's powerful IG Metall engineering union recently struck a wage deal that will raise paychecks by 3.5% this year and 3.1% next. That could set the trend for wage negotiations across the euro zone.

The logical response would be for the ECB to raise rates. But it's not so simple. Prices are rising much more slowly in the core euro-zone countries, such as France and Germany, than in Greece, Portugal, and Spain. When the smaller economies were growing faster than those in the core, that didn't matter much, because price rises were accompanied by rising productivity and big output gains. Besides, it was only reasonable to expect prices on the rim to play catch-up with those in the center.

But the situation has changed significantly in the past year. The smaller economies are growing more slowly. José Luis Alzola, an economist at Schroder Salomon Smith Barney in London, says growth in Spain, Ireland, Greece, and Portugal averaged 4.1% between 1995 and 2000, vs. 2.1% in Germany and France. For the next five years, he predicts, the performance gap will narrow to one percentage point or less.

Yet the inflation gap will be almost as wide as ever, which will sap growth even more in the smaller economies. On June 10, the Central Bank of Ireland warned that if inflation in the Emerald Isle is not brought down from April's 4.8% to 1%, growth could be stymied. Central Bank Governor John Hurley says inflation is the biggest threat to Ireland's export-oriented economy. He is demanding that the government curb spending and that the unions limit their wage demands.

If the ECB--which is required by law to maintain price stability--responds by raising rates in the next month or two, that might help nudge inflation down in places such as Ireland and Portugal. But it could shatter the fragile recovery right across the euro zone, and especially in Germany and France, where prices are still under control, despite what consumers might think. Instead, many economists urge the ECB to raise its inflation ceiling to 2.5%. That, however, is a cop-out the bank's monetary hawks aren't about to take. Their message is clear: Europe must learn how to grow without the booster shot of inflation. A recovery? Sure. But it will be joyless and slow.

By David Fairlamb in Frankfurt

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