Euro hits new high as rebound gains speed Eric Pfanner International Herald Tribune Thursday, May 30, 2002
But concern mounts over possibility of rise in interest rates
LONDON A series of upbeat reports show that the European economy is gaining strength, helping to lift the euro to a 14-month high against the dollar Wednesday and sparking concern over looming interest-rate increases.
France said Wednesday that business confidence rose more than expected this month, following similar reports from Germany, Italy and Belgium. France and Germany earlier reported steady, if unspectacular, gains in economic growth for the first quarter, setting the stage for a similar report on the 12-nation single-currency zone on Thursday, after weakness in the fourth quarter of last year.
Though Europe's biggest economies are hardly clones, they appear to have sidestepped the phantom menace of recession. In Germany, exports of BMWs are booming, even if buyers remain scarce at home. In France, however, cars are flying off dealers' lots, giving a lift to the domestic industry. In Britain, where home prices are soaring, consumers are splurging on all sorts of goods, though manufacturers are down in the dumps.
Inflation, meanwhile, appears to be moderating for now - though the longer-term outlook for prices could be the critical variable that determines the strength and sustainability of the European rebound.
"The euro-zone economy may be headed for a sweet spot in the business cycle where GDP growth is quite strong but inflation is low," said Michael Taylor, economist at Merrill Lynch. That appealing blend is drawing investors into the euro, which rose Wednesday to 93.56 U.S. cents in New York. The fledgling currency, whose trajectory has been mostly downward in the first 3½ years of its existence, is enjoying one of its first sustained rallies against the dollar. Though the U.S. economy surged ahead at an annual rate of 5.6 percent in the first quarter - far outpacing the expected 1.2 percent annual rate for the euro zone - investors are concerned that U.S. growth, aided by special factors, may not be sustainable at anything approaching that level.
Some analysts say the currency markets may have gotten ahead of the game. While Europe is recovering from a cyclical downturn, the structural factors that impede its competitiveness against the United States - such as more rigid labor markets and higher taxation - remain solidly in place. A generous wage agreement reached recently with German workers could kindle Europe-wide inflation, forcing the European Central Bank to raise interest rates, thereby snuffing out the renaissance before it really catches on.
"With key economies stagnant, profits still at risk, inflation rising and tighter money likely, there are no sources of economic recovery in sight," said Carl Weinberg, chief economist at High Frequency Economics.
But that is where the rising euro should help. Though it could eventually make European goods more expensive in markets such as the United States, exports have been holding up well for now. The problem has been sluggish consumer spending in the biggest euro-zone economy, Germany. A stronger euro would increase purchasing power there. And by cutting import prices, it could keep inflation in check despite the 4 percent pay raises recently won by the IG Metall union. Taylor at Merrill Lynch predicts that inflation in the euro zone will fall below the ECB's 2 percent target this summer.
In that case the bank could exercise restraint over monetary policy, keeping interest rates near the emergency lows to which they were pushed after the terrorist attacks of Sept. 11. Most economists say the ECB and the Bank of England, both of which meet next week, will keep borrowing costs unchanged for at least another month.
After that, the guessing gets trickier. Audrey Childe-Freeman, economist at CIBC in London, thinks the ECB will hold off until September. "They can afford to wait a little longer," she said. "There is risk that if they move too early, it could have a real negative effect on growth."
But economists at Morgan Stanley expect the bank to raise its main rate by a quarter point July 4, as a sort of warning shot. In the wake of the IG Metall settlement, the bond market - based on the difference in yield for a standard French 10-year note and a comparable inflation-indexed note - assumes that inflation will rise above the bank's 2 percent limit.
"In other words, the bond market is telling the ECB that it does not trust the bank to keep its promise to keep inflation to 2 percent over the medium to long term," the economists write.
Still, Morgan Stanley expects future rate increases to be modest, not enough to choke off an economic recovery.
The ECB president, Wim Duisenberg, has taken a more hawkish tone in recent comments on inflation. "Excessive wage increases will increase costs and create inflationary pressures," he said following the IG Metall deal.
In Britain, the outlook for the Bank of England is perhaps even more clouded. Low interest rates have fueled a spending spree as consumers, many of them taking out home-equity loans as home prices soar, have shown an American-style appetite for debt. Meanwhile, the manufacturing sector shows only tentative signs of recovery and the overall economy, which had been the strongest of the Group of Seven nations last year, moved to the bottom of the ranks in the first quarter when it showed no growth.
Some economists are concerned that if the Bank of England continues to hold off, it could allow a bubble to build up in housing prices, whose eventual deflation could have severe consequences for an already fragile economy.
On the Continent, manufacturing appears to be in better shape. The Ifo research institute's index of German business confidence, considered a reliable indicator of future economic prospects, was stronger than expected, rising to 91.5 points in May from 90.5 in April. Significantly, one component of the index - showing the level of manufacturing orders in hand - rose strongly, suggesting that activity at factories will continue to be robust.