Monday, April 28, 2008

Europe Braces for Inflationary Shock

http://www.iht.com. FRANKFURT: Europe is facing a "very strong inflationary shock" as a result of rising energy and food costs, the top European Union official for economic affairs said Monday as the price of oil neared $120 a barrel.

Joaquín Almunia, the EU commissioner for economic and monetary affairs, said that higher inflation was emerging as "a big punishment to the weakest sectors of society," because it eats away at the purchasing power of people who have seen their incomes stagnate in recent years.

His remarks came as the European Commission revised its forecast higher for inflation this year, to 3.2 percent from 2.1 percent in 2007, well above the target of just under 2 percent that the European Central Bank aims for.

In response, Almunia said that governments should revamp laws and regulations that keep prices high. In the past, European officials have said that these measures include fostering greater competition in the services sector and keeping down administrative price increases like fees and sales taxes.

"We need to be concerned not only because of economic reasons but also because of social reasons," Almunia said, "and we need to ask the governments to step up their efforts of adopting structural reforms that can counter these inflation risks."

Commodity price increases, driven by rising demand from fast-growing Asian economies, have turned into a curse for the global economy this year, contributing to higher inflation around the globe.

Almunia acknowledged that inflation was biting hard in Europe this year because incomes have not risen during the current economic upswing as they have in past expansions, amplifying the feeling of being squeezed in many households.

"The disposable income of households is not increasing as much as in previous recoveries," Almunia said, "and this means wage increases have not increased so far as much as in previous recoveries."

The ECB has inflation, which hit a 3.6 percent annual rate in March, firmly in its sights, as required by its legal mandate. Jean-Claude Trichet, the ECB president, said Monday in Vienna that the central bank would set interest rates based on "no other considerations than the delivery of price stability in the medium term."

In recent weeks, the tough stance of a number of senior ECB policy makers on inflation has contributed to a broad impression that at least some officials are itching to raise interest rates as soon as the current financial market tension eases. The muscular euro, which helps keep import prices down, has probably also helped curb any ECB rush to lift borrowing costs, economists believe.

"There is no doubt in my mind that without the financial crisis, and maybe the strong euro, they would have long since hiked rates," said Erik Nielsen, chief Europe economist at Goldman Sachs in London.

Like central bankers, Almunia has frequently cautioned against wage settlements that incorporate these price rises into pay scales, since they raise the likelihood that companies then pass the costs along to consumers, fueling inflation. But he singled out Germany as one place where rising wages should bolster consumer spending after years of relying on exports for growth, a development that would help growth across Europe.

"This more normal evolution of wages in Germany is good for evolution of private consumption, for growth in Germany and for a more articulated way to growth in the euro area," Almunia said.

German consumer confidence rose in April to its highest level since October, according to a closely watched survey by the research firm GfK.

The data appear to support hopes that German households might be shrugging off the financial turmoil, though they are worried about inflation.

The current European expansion will cool somewhat this year, the commission predicted Monday, with economic growth in the 15-country euro area hitting 1.7 percent for 2008, not the 2.2 percent it forecast in the autumn. The euro-zone economy grew 2.6 percent in 2007.

Almunia also said that the strong euro, which so far has shown little sign of pinching European growth, would eventually hit, and be amplified by, a weaker world economy. The euro is now hovering below its all-time high of just above $1.60, but is probably still "overvalued," Almunia said.

Almunia also used the occasion to deliver a warning to France, where he said the budget deficit was growing and would hit the 3 percent ceiling imposed by EU rules unless something changed.

The EU could issue a warning to France, which would be politically awkward for President Nicolas Sarkozy, who has staked his presidency on economic reform. It could also eventually impose financial sanctions, though this step has proved much harder to take since the rules were imposed in 1998 to support the euro.

"That is a clear case to consider using the instruments that are in our hand for such cases," Almunia said.

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