The European Central Bank's interest rate policy is being thrown into disarray by escalating inflation across the euro zone.
The Bank's main function is to ensure price stability. How to define price stability was its choice. With the influence of the Bundesbank coming to bear, it picked an extremely onerous target - inflation would have to remain between zero and 2 per cent over the medium term.
Now headline inflation is 3.4 per cent, getting towards the high end of Federal Reserve or Bank of England tolerances but surely calamitous for the ECB. To make matters worse, core inflation, which excludes all the volatile components that interest rate policy cannot affect such as energy and food prices inflation, is also above the target rate at 2.1 per cent.
The big fear now must be stagflation - with growth falling and inflation soaring. That is every banker's worst nightmare. After the last rate cut in May, momentum had been building for another in the summer. Growth in Germany, France and across most of the euro zone is falling and a rate cut would help stave off the worst.
But now rising prices, even in countries like Germany, may have put an end to that. News that French inflation had jumped to 2.5 per cent and Germany's to 3.6 per cent dashed hopes that Dublin could be the location for the next rate cut.
Officials must hope that this month's 3.4 per cent inflation rate will be the peak, now that the worst of the foot-and-mouth crisis is past, but there are no guarantees. Some observers believe that even if this is the peak, inflation may not drop much below 3 per cent over the rest of the year.
This is bad news just as the notes and coins are introduced and as the German wage round begins in earnest.
What is a cause for some concern is that inflation is passing through to a much greater extent in Europe than in the US. Part of this is the result of the very weak euro, particularly as oil is priced in dollars. But some analysts are also pointing to the lack of structural reforms in Europe that allow big corporations to increase prices quickly. In the US, by contrast, the corporations have had to absorb higher energy costs and profits have been squeezed.
A resurgent euro would answer the ECB's prayers as it would offset the higher cost of fuel. But there are no real signs that any turnaround is on the horizon. The classic cure of intervention and higher interest rates is impossible. The Bush Administration is ideologically opposed to intervention, while higher rates could be the final nail in the coffin of Europe's hard-hit economies.
The ECB now has a very fine balancing act between cutting rates to stave off recession and adding any further upward pressure to prices.
