ECB faces dilemma as euro zone inflation rises

Gulf Daily News ^ | 9/29/2007

[bruinbirdman]

BRUSSELS: Euro zone economic activity is set to weaken while inflation is on the rise, data showed yesterday, leaving the European Central Bank (ECB) with a tough dilemma whether to abandon its tightening bias.Eurostat said euro zone inflation rebounded this month above the ECB's target for the first time in a year, but a monthly European Commission survey showed market turmoil depressed economic sentiment, pointing to slower growth ahead.

"Essentially, this ... provides a summary of what is facing the ECB in the coming months - slackening activity data but uncomfortable short-term inflation trends," said Dominique Bryant, economist at BNP Paribas.

"This is a recipe for no change in rates, but with the risk increasingly that, further ahead, growth worries start to dominate," he said.

Prices in the 13 countries using the euro rose 2.1 per cent year-on-year against 1.7pc in August - a jump economists attributed to an annual surge in oil prices.

The ECB wants inflation just below 2pc and even though it left interest rates unchanged at 4pc this month to help calm financial markets amid a global credit crunch, it has signalled it could raise them due to upside inflation risks.

Economists also expect inflation to stay above the ECB's target for the rest of this year, possibly reaching 2.4-2.6pc in December, but then to start easing again next year as growth slows easing the pressure on the labour market and wages.

"Falling inflation rates and clear signs of the economy cooling off will cause the ECB to give up its tightening bias.

For the end of 2008 we expect a first rate cut," said Commerzbank economist Christoph Weil.

Many forecasters, including the ECB and the commission have cut their 2007 euro zone economic growth forecasts in the wake of the financial market turbulence in August and September, expecting the confidence shock to curb expansion.

The commission's survey showed the global credit crunch, caused by the US subprime mortgage market crisis, had a bigger than expected impact, cutting economic sentiment to the lowest level since May 2006 at 107.1 points from 109.9 in August.

Germany, the euro zone's biggest economy, and second biggest France were among the most hit.

German consumer confidence, long trailing the optimism of the industry, halved to three this month and the retail sector sentiment plummeted to -17 from -10.

German retail sales, an indication of consumer demand, in August surprised economists with a decline instead of a rise as inflationary worries spooked consumers, who remain reluctant to spend despite a sustained improvement in the labour market.

In France consumer confidence fell two points to -5 points and the retail sector's sentiment tumbled to one from four.

But the Euroframe network of economic think-tanks said it believed the credit crunch was a short-term blip in the liquidity of the banking sector and that euro zone growth this year would still be 2.7pc - a figure the commission and ECB have now both reduced to 2.6pc.

[J Aguilar]

There is no dilemma, since the task of the ECB is to contain inflation, not economic growth. The ECB is not responsible of French and German reluctancy to carry out reforms in their economies. France has avoided to fulfill the deficit target under Sarkozy term, and in Germany chancellor Merkel even undid some of the very unpopular changes carried out by Schroeder, trusting just in, as they say, the Weltkojunktur, that is, the growth of the rest of the world, to pull Germany’s economy out of stagnation. Once the mirage was blown up by the credit crunch, we will see if she has what it takes.

Moreover, interest rates at 4% are still low, being the neutral point 4.75%. The ECB is carrying out a loose monetary policy, having no room to maneouver, as the Federal Reserve did if something very bad, such as another 9/11, happens. Furthermore, the impact in economic growth of reducing already below the neutral point interest rates is arguable, whilst in inflation is clear.

[Moonman62]

The problem is oil prices. All countries need to look at coordinating policy to strengthen the dollar since oil is priced in dollars. Countries that subsidize the consumption of oil need to stop. And all countries need to adopt supply side economics.

Raising interest rates, especially outside the US is going to cause more problems than it solves.