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Inflation a threat, but growth critical

23/06/2008 - 13:49

By Steven C. Johnson

NEW YORK (Reuters) - Now that everyone agrees that it's inflation, not a lingering credit crisis, that poses the gravest risk to the world economy, it's time to think again about central bankers' focus.

While policy-makers have grown increasingly shrill in their warnings about the danger of $135-plus oil, there's very little they can do so long as growth, particularly in the developed economies of the United States and Europe, remains sluggish.

With banks still struggling to shore up their balance sheets and consumer confidence deteriorating on both sides of the Atlantic and in Japan, resorting to higher interest rates to counter inflation may do more harm than good.

"The Federal Reserve and the European Central Bank cannot control commodity prices," said David Kelly, chief market strategist at JP Morgan Funds in New York.

"Every time we have a bubble, we say we'll raise interest rates. But that's like trying to swat a fly with a sledgehammer -- you miss the target but cause a lot of collateral damage."

That's not to say commodity gains haven't been swift and painful. Oil prices have surged 40 percent so far this year, and truckers, taxi drivers and farmers from Spain to Israel to Nepal have taken to the streets in protest.

The problem for Western central banks, though, is that they have no control over the factors driving commodities up -- soaring demand in emerging markets such as China and India and a speculative bubble inflated by investors around the world.

For the United States, with its gas-guzzling SUVs and whirring air conditioners, some economists fear high oil prices may put a freeze on hiring and spending. That would be an even bigger threat to the economy than higher inflation.

If hiring and spending slow significantly, higher interest rates could tip an already fragile economy, which limped along at a 0.9 percent growth rate in the first three months of the year, into full-fledged recession.

TALK INSTEAD OF ACTION

The vexing combination of sluggish growth and rising prices should keep the Federal Reserve from lifting interest rates on Wednesday, though officials will likely keep talking tough on inflation, partly to forestall further dollar weakness.

The Fed cut rates sharply, to 2 percent between September and April, to ward off recession, weakening the dollar in the process. Fed Chairman Ben Bernanke seemed to put on the brakes in June, linking a weak dollar to the rising cost of imports.

Because oil is priced in dollars, its price rises when the dollar slips. That raises fuel costs for Americans and stunts growth in the world's largest economy. But for non-U.S. consumers, it makes oil cheaper, boosting demand.

JP Morgan's Kelly said talk is good if it holds inflation expectations in check and prevents investors from changing their buying habits or consumers from demanding higher wages.

But hiking rates is a tougher sell with U.S. housing prices still plummeting, consumer confidence at a 16-year low and the jobless rate spiking to 5.5 percent.

A clutch of U.S. housing and consumer sentiment data this week may add more gloom to the outlook for the second half.

Meanwhile, Wall Street banks are still fighting to regain their earnings power -- Morgan Stanley said second-quarter profits plunged 60 percent -- and a star hedge fund manager predicted more credit turmoil to come.

"In our view, the Fed is barking now because deep down inside, it knows it can't bite with the macroeconomic and market backdrop as fragile as it is," Merrill Lynch economists wrote in a note to clients.

Of course, commodity price inflation is serious business in developing Asia, which imports nearly all its oil and where food makes up a large part of the consumer price basket.

But while central banks there have hiked interest rates, they can use other tools to cool inflation as well, including appreciation of their undervalued currencies.

Last week, China became the latest Asian country to hike gasoline prices by cutting fuel subsidies.

Tony Crescenzi, chief bond market strategist at Miller, Tabak & Co in New York, said the move should help cool strong Chinese consumer demand "and perhaps lower the oil price."

WALKING THE TIGHTROPE

Inflation fears are even more pronounced in the 15-country euro zone, and ECB President Jean-Claude Trichet has all but assured markets of an interest rate hike in early July.

But even with consumer price inflation hitting a record high 3.7 percent in May, economists say the bank is walking a tightrope. Its economists have already downgraded growth forecasts for this year and next, while weak housing markets in Spain and Ireland would suffer more pain with higher rates.

This week, Monday's German Ifo survey, which measures business sentiment in the Europe's largest economy, will be watched closely, as will a report on French consumer confidence.

ECB officials have been at pains to disabuse markets of the notion that they will launch a series of interest rate hikes, but some economists say that's probably what it would take to neutralize the impact of food and energy price gains.

"Problem is, that would lead to quite a recession," said Carl Weinberg, chief economist at High Frequency Economics in Valhalla, New York. "Trichet and the Europeans are overly obsessed with inflation."

(Editing by Editing by Dan Grebler)


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