Daniel Roland
Unlike the U.S. Federal Reserve, the European Central Bank is obsessed with "price stability" -- banker speak for inflation busting. Ditto the Bank of England, where job No. 1 is keeping inflation at no more than 2 per cent "at all times," never mind the state of the economy.
Given the central banks' mandates, you would assume that interests will rise, and soon. That's because inflation has made a rude comeback in the European Union. The German inflation rate, reported Friday, increased to 1.9 per cent in December from November's 1.6 per cent, the fastest rise in two years. Consumer prices rose 1.2 per cent, the biggest gain since late 2002.
On Thursday, ECB president Jean-Claude Trichet reminded the journalistic throng in Franfurt that he might soon have to pay attention to what he's paid to do, which is keep a wary eye on inflation. Inflation in the euro zone -- the 17 EU countries that share the euro -- accelerated to 2.2 per cent in December, breaching the ECB's 2 per cent limit for the first time in more than two years. Meanwhile in Britain, inflation rates are galloping towards 4 per cent, double the target. The culprits are surging food and energy prices, coupled with a value-added tax hike and a weakish pound, which makes imports costlier.
The solution seems easy: Crank up interest rates. It's not. For the ECB and the Bank of England, any decision to leave interest rates low, or boost them to whack inflation, is fraught with risk. That's because Britain and half of the euro zone (Britain is a member of the EU but not the euro zone) still qualify as economic disaster areas. Growth in many countries is anemic to negative, unemployment is high and the threat of social unrest disturbs the sleep of even cold-blooded political leaders.
Take Germany. The German economy is on fire -- it expanded at a record 3.6 per cent last year -- and Germans have a cultural dread for inflation. They have no doubt that the ECB, whose halls are patrolled by former Deutsche Bundesbankers, should do the right thing and raise rates. But the ECB has other countries to worry about besides Germany.
The Greek Irish and Spanish economies contracted last year, meaning higher rates couldn't come at a worse time. The big question is whether Germans can be convinced to accept high inflation rates in exchange for using low interest rates to, in effect, bail out dud economies. They may not, given the fact that German taxpayers are already the single biggest sponsors of the bailouts of Greece and Ireland, with Portugal evidently next in line for a rescue.
The story is similar in Britain. Growth has indeed returned. But thanks to a punishing austerity program, it's nowhere near German levels. The growth estimates for 2010 range from 1.2 per cent to 1.9 per cent, and unemployment remains stuck at just under 8 per cent (the European Commission expects British unemployment to rise next year). An interest rate hike would only make a bad situation worse.
So what is the Bank of England to do? The first question is has to answer is whether raising rates would actually tame inflation. It may not, if you consider that some degree of inflation is imported. The bank can do nothing to prevent the prices for imported food and fuel from rising. It also has to factor in the effects of the rise in the value-added tax, which went from 17.5 per cent to 20 per cent this month. That hike was a one-off event that probably skewed the inflation figures.
Here's a guess on my part: Both the Bank of England and the ECB will be slow to raise rates, if they raise them at all this year. With the British economy and half of the euro zone still in the economic tank, the risks of a rate hike are simply too high, especially when you consider that even talking about rising rates will boot the value of sterling and the euro (as it has already). Meanwhile, the central banks will be praying that commodity prices will politely do the right thing and come down.
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