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FRANKFURT, June 12: If European Central Bank President Jean-Claude Trichet hopes to dull inflation pressures by talking up the euro, he may be in for a disappointment.
Trichet’s blunt hint last week that the ECB may lift euro zone interest rates as early as next month pushed the euro up sharply against the dollar, yen and sterling the currencies of its major trading partners.
In theory, this should help keep a lid on soaring inflation by depressing the prices of the near 1.5 trillion euros worth of imports arriving in the euro zone every year.
But this dampening effect is diluted by the fact that oil prices are rising even faster than the single currency.
At the same time, the US Federal Reserve is potentially spiking the ECB's guns by pursuing similar tactics to bolster the weak dollar and temper the impact of imported inflation on its own struggling economy.
Trichet and Fed Chairman Ben Bernanke have both cranked up the anti-inflation rhetoric in recent days with some economists seeing the tit-for-tat timings as a sign both men are keen to boost their own currencies.
Bernanke shocked markets last week by saying a weaker dollar was adding to inflation risks a rare departure from the usual Fed reticence on the dollar. Two days later, Trichet delivered his own shock by saying that the ECB could raise rates.
“You might wonder if we are seeing a case of beggar-thy-neighbour policies with both sides paradoxically trying to talk up their currencies exactly because they see that as the only way to reduce the imported inflation pressures from commodity prices,” UniCredit economist Marco Annunziata said.
The winner could ultimately be the central bank which is not only prepared to draw its gun, but also fire the most shots.
“If Bernanke is just speaking and Trichet acts, it's hard not to believe actions will not trump words in the currency market,” said Alan Ruskin, chief international strategist at RBS Global Banking & Markets in Greenwich, Connecticut.
However the US is a far bigger net importer than the euro zone and economists point out that that the euro could feel the pressure if the Fed is successful in sparking a resurgence in the dollar.
“I think the ECB has been quite happy to take the softening effect on inflation of lower import prices but it's difficult at the moment because there are increasing signs that the Fed has finished its rate cutting cycle,” said HBOS economist Mark Miller.
“It could lead to a stronger dollar going into next year and what the ECB was comfortable with in terms of softer import prices now, might actually reverse and prices could go back up.”
EURO CHAMPION: The euro has risen as much as 11 per cent against the dollar this year as the ECB has held rates steady in contrast to rate cuts by the Fed. It has also risen against a basket of other major currencies.
The rise has the bonus of making imports cheaper and taking some of the sting out of the recent spiral in oil prices, although exporters are suffering.
“There's no doubt that the euro going up helps offset some of the increases in oil prices but the pace at which oil prices have increased has dominated the increase in the currency,” Deutsche Bank economist Mark Wall said.
Over the last year, the price of a barrel in oil has doubled in dollars but its rise in euros has been capped at 77 per cent, due to the euro's strength.
But as the euro has risen, the dollar has fallen to historic lows and caused a vicious circle by aggravating the pain of surging oil and commodity prices. Since the start of the year alone oil prices have risen 40 per cent. Following Trichet's comments, crude hit a record high of $139 a barrel on Friday and notched its biggest-ever one-day gain.
As oil is mainly priced in dollars the theory goes that as the value of the dollar drops, crude prices rise and you need more dollars to buy the same barrel of oil. Investors also use oil as a hedge against the dollar, and a weaker dollar makes dollar-denominated commodities more attractive.
Energy bills account for around 10 percent of the ECB's inflation measurement and every $10 increase in the price of oil adds roughly 0.15 percent to inflation as well as pushing up the price of producing goods from food to furniture.
The prices rises erode the benefits of the stronger euro and create more headaches for an ECB which is trying hard to push down record inflation which returned to 3.6 percent in May.
“It's an issue of proportion in that the move up in oil prices was very significant and I don't think you can hope to have such a strong appreciation of the euro that you can hope to completely offset the move,” said UniCredit's Annunziata.—Reuters
