The Irish Times just reported that Eurozone inflation increased to 3.6% in May. This certainly reduces the chance of the European Central Bank (ECB) cutting rates on June 19, when it meets again in Frankfurt. Why? The ECB’s primary stated objective is to maintain price stability by keeping inflation at or below 2%. Its secondary goals are promoting a "high level of employment" and "sustainable and non-inflationary growth among the member states.” So what does this mean for the euro; will it hit new highs against the dollar?
Will ECB President Jean-ClaudeTrichet allow slower growth and possibly job losses as the central bank tries to tame inflation?
Probably yes. Trichet, said this month that the ECB would not consider changing its mandate "for one second." So despite a slowing economy, it is highly unlikely that the ECB will cut rates. Instead, I believe they will be left on hold near term, and then increased a quarter point to meet the prime inflation objective.
Consider a sampling of inflation by country from the just-released report on inflation in the Eurozone:
Netherlands = 1.7%
Switzerland = 2.3%
Spain 4.7%
Germany = 3.0%
Belgium 5.2%
Estonia = 11.6%
Iceland = 11.7%
Currently, only the Netherlands is under the target 2.0% inflation rate. And for countries, the real interest rate is negative (real interest rate = nominal rater - inflation). In Iceland, it is -7.7%. In Belgium it is -1.2%. Negative real rates fuel further inflation and are a disincentive to invest. It is clear from the above figures that the ECB has its hands full with a "one size fits all" economic policy that cannot be tailored to each state, but must instead strike a middle ground. And that middle ground will be higher rates.
This will mean further weakening for the US dollar against the euro. I estimate that the euro will exceed $1.65 by year end, unless the federal Reserve raises rates, which it is unlikely to do over the next six months.
Note that that ECB does not use the US core inflation definition – food and energy are included in EU inflation statistics. This is an approach grounded in reality, and one that the Fed would do well to adopt.
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