Tax cuts or wage rises to compensate for higher oil prices will result in higher interest rates, the European Central Bank has warned.
In its September monthly bulletin the ECB warned that high wage growth will fuel inflation and "monetary policy would need to react to the resultant upward pressure on prices".
Reacting to pressure across the EU to cut fuel taxes and increase wages in response to higher oil prices, the ECB issued a stark warning to euro zone governments. It said they also have to play an important role not to convey the false impression that the costs for the economy as a whole stemming from the oil price increase could be avoided by relaxing budgetary policy.
"Recent oil price movements have also caused terms of trade to deteriorate and thus have reduced real income. But it is essential that wages continue to grow at rates compatible with maintaining price stability. Any attempt to raise wages in response to recent oil price increases would be highly detrimental to current favourable growth and economic prospects," it warned.
According to Mr Jose Luis Alzola of Schroder Salomon Smith Barney, the ECB has previously made rhetorical warnings about fiscal and wage policies, but this time the ECB seems "genuinely concerned", probably because inflation is set to remain above 2 per cent for up to another seven months.
He added that he expects another interest rate increase by November and further hikes until the end of 2001. According to Mr Alzola, data released after the cut-off date for the publication of the bulletin will only add to the ECB's anxiety. Based on preliminary numbers from Italy and Germany, it appears that euro zone inflation will accelerate to 2.5 per cent or so in September, following a slight moderation to 2.3 per cent in August.
But it also noted that inflation is set to slow slightly next year to just below 2 per cent, although the euro's low valuation and the oil shock is creating worrying upward pressure on prices.
However, Dr Dan McLaughlin, chief economist at ABN-Amro disagreed. He noted the ECB left out its customary warning that the risks to price stability in the medium term continue to be on the upside. This may mean that if wages do not rise rapidly and taxes are not cut dramatically that they may not be inclined to increase rates in the next month or two. "It may mean they are saying `let's wait and see'. That would be consistent with the message of ECB president Mr Wim Duisenberg at the press conference last week," he said.
The ECB also attempted once again to talk up the value of the euro which closed up yesterday at $0.8558 up from $0.8459 a day earlier. Dealers said the chances of a concerted effort to underpin the euro at the upcoming meeting of the Group of Seven industrialised nations this weekend buoyed the currency.
The ECB repeated that the overall positive outlook for the European economy is not reflected in the value of the euro and "contrasts more and more with economic fundamentals". It pointed to the growing US trade deficit, now at a record high, stating the euro's low value is "increasingly out of line with global current account developments".
