Saturday, April 16, 2011

U.S., EU: Identical Inflation, Opposite Policies

By Brian Blackstone

U.S. and euro zone inflation were at identical 2.7% annual rates in March, according to their respective statistics agencies in separate reports Friday. Core inflation is more or less the same (1.2% in the U.S., 1.3% in the euro bloc). Until last month, inflation had been running slightly faster in the euro zone.

Yet given the same set of inflation dynamics, the European Central Bank has already raised interest rates once and, based on Friday’s report, is likely to do so again as early as June. The Federal Reserve, in contrast, continues to pump money into the economy via QE2, and isn’t expected to lift interest rates from near zero for many months.

In large part, it’s a difference of emphasis. Fed officials think higher commodity prices are temporary, and that core inflation is a better gauge of underlying price trends. ECB officials target headline inflation, and worry that higher energy and food prices will filter through the economy via “second round” effects, namely higher wages and retail prices.

There are other forces at work, too. The U.S. has a higher growth potential, meaning the recession created a larger output gap there than it did in Europe. That presumably gives the Fed more time to see how long higher commodity prices stick.

The Fed also has a dual inflation-employment mandate (the ECB is only responsible for keeping inflation just below 2%). Though unemployment in the euro zone is higher than it is in the U.S., ECB officials think that is more a structural issue for governments than it is a monetary-policy problem.

Whatever the reasons, the two biggest central banks in the world can’t have such divergent views without consequences down the road.

If the ECB is right and higher commodity-driven inflation must be addressed quickly, then it may be able to keep inflation expectations under control without large-scale rate increases. If the Fed errs in waiting too long, it could be forced to play catch-up with more aggressive, and damaging, rate increases down the road.

If, however, the ECB is being unnecessarily spooked by commodity prices that are largely outside its control, it may unnecessarily damage the economy, especially in the already fragile periphery.

That may already be occurring. In a note explaining its downgrade of Ireland Friday, Moody’s Investors Service said, “the Irish government’s financial strength may suffer as a result of what may be the first of a series of policy rate increases by the European Central Bank to slow the rise in euro area inflation.”

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