Wednesday, January 5, 2011

Inflation Rises in the Euro Zone

Inflation Rises in the Euro Zone

Prices Outpace Central Bank's Target, Complicating Bid to Stem Fiscal Crisis

FRANKFURT—Euro-zone inflation jumped past the European Central Bank's target for the first time in more than two years, threatening the ECB's coveted anti-inflation credibility as it continues to take aggressive measures to stem the region's fiscal crisis.
Annual inflation across the currency bloc was 2.2% in December, according to the European Union's statistics office, Eurostat, up from 1.9% in November and the highest since October 2008. Tuesday's report didn't provide a country or product breakdown, though economists said the rise was likely due to higher food and energy prices.
The ECB's mandate is to keep inflation just below 2% over the medium term. Inflation had dipped into negative territory in late 2009 as the global recession drove prices down and kept wages in check, and was under 1% as recently as February 2010.
But the euro-zone economy's subsequent turnaround, led by Germany, reversed that trend. Gross domestic product grew robustly in the middle of last year and carried that momentum into the end of the year. Still the ECB, under President Jean-Claude Trichet, has kept crisis-era programs in place, including record-low interest rates, abundant loans to banks and, for the past eight months, purchases of government bonds to help vulnerable countries such as Greece, Ireland and Portugal that face high debt levels and meager growth prospects.
"If inflation is rising, this will make it harder for Trichet to justify his actions," says Charles Wyplosz, professor of economics at the Graduate Institute in Geneva.
And it won't get easier anytime soon. Barclays Capital expects the inflation rate to rise to 2.3% this month and 2.5% in February. "The monetary stance does look on the easy side" against those figures, says Barclays economist Julian Callow.
Mr. Trichet repeatedly cites his anti-inflation bona fides as a defense from critics, particularly in Germany, who say ECB policies will lead to higher prices. Mr. Trichet recently recalled a meeting with European parliamentarians where he noted that the ECB has delivered 1.97% average inflation over its first 12 years, a figure he frequently cites. "We even had applause. I was quite moved," he said.
Inflation rates slightly above 2% aren't yet a threat to Mr. Trichet's track record, economists say, noting that when food and energy prices are stripped out, core inflation is closer to 1%. But risks of a more prolonged rise in prices are mounting. Cold weather has pushed up energy and food prices, and a revival in global growth could keep commodity prices elevated for some time. Consumption taxes in parts of Europe may lead to higher wage demands, while in Germany a robust economy is giving workers their strongest bargaining position in many years. Despite a small rise in unemployment last month—the first since June 2009—German unemployment remains near 7%, among the lowest in Europe.
As a result, German unions, which at the height of the crisis traded wage gains for job security, are demanding steeper wage increases to offset rising prices.
It isn't just countries on sound economic footing that face rising wages and prices. On Monday, Spain reported that inflation closed the year at 2.9% despite that country having an unemployment rate above 20%, reflecting higher tobacco and household-power prices and a value-added tax-rate increase that became effective in July. "The risk of an increase in wages in line with recent inflation could be a problem" if they depress profits, investment and hiring further, says Maria Jesus Fernández, economist at Madrid-based think tank Funcas.
The usual response by central banks to such risks would be to tap the brakes by raising interest rates or withdrawing other stimulus. Germany, France and other big economies could handle higher rates, but they would cripple vulnerable countries in Southern Europe and Ireland by driving up already high debt costs, economists warn.
That will keep the ECB under pressure to deliver more stimulus, not less, despite higher inflation. Many economists say that with Portugal and Spain likely to come under pressure in coming weeks as they issue billions of euros in new government bonds, the ECB will have to step up those purchases even more. "The ECB needs to ensure that the euro area hangs together to start with; there are bigger issues at hand" than inflation, says Mr. Callow.
—David Roman
contributed to this article.

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