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Inflation in Europe reported at 16-year high

Section: Daily Dispatches

By Fergal O'Brien
Bloomberg News Service
Thursday, July 31, 2008

Inflation in Europe accelerated to the fastest pace in more than 16 years in July, restricting the European Central Bank's room to bolster the economy even as unemployment starts to increase.

The inflation rate for the 15-nation euro region rose to 4.1 percent from 4 percent in June, the European Union statistics office in Luxembourg said today. The rate, the highest since April 1992, matched the median estimate of 36 economists in a Bloomberg News survey. A separate report showed unemployment was 7.3 percent in June, exceeding the 7.2 percent median forecast.

The ECB, which aims to keep inflation just below 2 percent, raised its key interest rate by a quarter point to 4.25 percent on July 3, a seven-year high. The risk is that higher borrowing costs will exacerbate the economic slowdown. Europe's manufacturing and service industries are contracting and confidence in the economic outlook this month plunged the most since the Sept. 11 terrorist attacks in 2001.

"The growth outlook has deteriorated," said Martin van Vliet, an economist at ING Group in Amsterdam, who doesn't expect the ECB to raise rates again. "But the ECB will keep open the possibility of one further rate hike because a wage-price spiral could be even more damaging than the economic downturn we're seeing now."

The euro rose to $1.5616 at noon in Frankfurt after touching $1.5522 yesterday, the weakest since June 24. Investors raised bets on another ECB rate increase, Eonia forward contracts show. The yield on the March contract rose to 4.37 percent from 4.32 percent before the inflation report.

... Second-Round Effects

The ECB wants to prevent companies passing on higher costs and has urged workers not to seek pay raises to compensate for increased living expenses, saying this may unleash a wage-price spiral. Workers at Deutsche Lufthansa AG, Europe's second-biggest airline, are striking in pursuit of a 9.8 percent pay claim.

A European Commission gauge of companies' selling-price expectations rose to a 13-year high in July and Italian wage growth accelerated to 3.6 percent in June, the highest in more than three years.

"We'll have to continue to raise prices because of higher raw-material costs," Juergen Hambrecht, chief executive officer of BASF SE, the world's largest chemical producer, said in an interview with Bloomberg Television today. "There's no way out. We're paying higher prices than we're charging."

Faster inflation is eroding purchasing power, weighing on the economy just as the euro's advance and a deepening U.S. housing slump hurt European exports.

... Unemployment Rises

The EU statistics office said today that unemployment rose to 7.3 percent in May from 7.2 percent in April, the first increase in three years. It previously reported a 7.2 percent rate for May.

"Barring a renewed and abrupt surge in oil prices, July may well be the peak of inflation this cycle," said Aurelio Maccario, an economist at Unicredit MIB in Milan. If oil prices "remain stable or start declining, then next year we may witness a change in the monetary policy stance."

Crude oil prices have retreated to around $126 a barrel after reaching a record $147.27 on July 11. They're still up 60 percent from a year ago, while prices for commodities including steel, corn and wheat have also soared.

The ECB has said Europe's economic fundamentals are sound. In June, it forecast the pace of euro-area expansion will slow to about 1.5 percent in 2009 from 1.8 percent this year and 2.7 percent in 2007.

... 'Room for Maneuver'

"We haven't exhausted our room for maneuver" on interest rates, ECB council member Klaus Liebscher said in an interview published July 25. "We're far from giving the all clear on the inflation development."

The ECB isn't alone in weighing the risk of stagnating growth against the danger of accelerating inflation. Bank of England policy makers were split three ways in their decision to keep interest rates unchanged this month.

The Swiss central bank has left borrowing costs unchanged since late 2007 as faltering economic growth limits its ability to counter the country's fastest inflation in 15 years.

Federal Reserve Chairman Ben S. Bernanke this month abandoned his June assessment that the threat of an economic downturn had diminished, telling lawmakers that both growth and inflation risks are increasing.

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