Tuesday, July 1, 2008

European Inflation has Dire Implications for U.S. Recovery

Despite comparatively high interest rates, European inflation is rising rapidly under the pressure of higher oil and commodity prices. June inflation in the Eurozone rose to 4% from 3.7% in May creating a conundrum for the European Central Bank (ECB). Inflation hawks will call on the ECB, which is constrained by its single mandate to control inflation, to increase interest rates in order to stave off inflationary pressures, despite significant unemployment among younger workers and anemic economic growth. Increasing Eurozone interest rates will result in further depreciation of the U.S. dollar versus the Euro by effecting higher import costs for U.S. consumers and fewer exports from Europe. The combination of higher interest rates, a stronger Euro, and a more challenging export market erodes economic growth in the Eurozone while concurrently resulting in further weakness in the U.S. dollar, rising import costs, and greater inflation in the United States. The integration of the global economy enables the diffusion of U.S. economic weakness and global inflation in commodities around the world.

Eurozone inflation (orange) spikes to 4%, approaching U.S. inflation of 4.25% (red), after years of stability at 2-2.5% annual inflation. (Source: Bloomberg)

Inflationary pressures are running rampant in the U.S. and Eurozone economies. What started with commodity driven inflation has dispersed throughout the economy affecting upstream products such as chemicals, food, and manufactured goods. Wage pressures are already increasing as Bloomberg reports that ground workers at Lufthansa are demanding a 9.8% increase in pay to cope with increasing costs and the erosion of their standard of living. Europe, with greater board level representation afforded to employee groups, will likely experience more rapid wage inflation than the U.S. due to the substantially higher bargaining power European employees wield. Ultimately, the inflationary forces in both the Eurozone and the U.S. will entail arduous decisions and portend dire economic consequences if inflation escapes the control of the central banks. The combination of sluggish economic growth, rising inflationary expectations, and mounting unemployment threaten to confound a difficult economic environment that has, thus far, been immune to monetary and fiscal stimulus.

The probability of an ECB rate hike is open to debate, but the recent discourse by policy makers suggest that it is increasingly likely as inflation ticks ever higher. With the U.S. Federal Reserve walking the tightrope of uncontrollable inflation and economic recession, the potential for continuing weakness in the dollar and higher import costs leaves policymakers in a precarious position. The traditional response of lowering interest rates to support economic growth has limited the options available to the Fed. Further monetary stimulus is constrained by the currently low rates and an already weak dollar, but interest rate increases would jeopardize the economy already teetering on the brink of recession. It is increasingly likely that the ECB will raise rates ultimately increasing the pressure on the Fed to follow suit. Absent a corresponding action by the Fed, further weakness in the dollar and increasing inflationary pressures in the United States can be anticipated. With the Presidential election just months away, expect the Fed to resist dramatic action in the interim resulting in serious economic challenges for the next administration. Be prepared for a wild ride!