June 30, 2008

Uh Oh

WELL, SINCE WE'RE IN the market for bad economic news, here's some more: European inflation has hit 4 pc. This almost certainly means the European Central Bank will raise interest rates when it meets Thursday. That's bad. That's very bad.

The reason, of course, is because it will increase the interest-rate spread between the Federal Reserve and the ECB, which now stands at two percent. The cost of funds for banks in the US is now 2 pc and in Europe it is now 4 pc. This difference may not seem like a lot, but since capital flows are uncaring about human feelings, any moves will further exacerbate the already-alarming disparity between the dollar and the euro, and thus make all sorts of goods from abroad more expensive. Like, say, oil.

Just one month ago it looked as if the ECB would actually have to start reducing its benchmark rate late this year or early next. But the Europeans, who remember their bouts with high, super-high and hyperinflation from the earlier part of last century, have a pathological aversion to inflation and so will fight it at any cost -- even if it means helping wreck their economy in the process (and perhaps ours).

It is true that inflation is too high for comfort at this point, but at the same time I wonder -- is it so bad that we need higher interest rates? Certainly these folks think so, but I'm not convinced. The last thing we need is a Volcker-esque strangling of the economy like we saw in the early 1980s.

True, Volcker faced a far different situation -- with inflation running at 14 pc, he had to break the cycle of inflation no matter the cost. Today, on the other hand, inflation is running about ten points lower, which in theory would give our economic masters a little leeway in balancing the inflation-growth equation. It would be nice if they used some of it.

Posted by Benjamin Kepple at June 30, 2008 11:00 PM | TrackBack
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