European Inflation Probably Accelerated to 4.1 Percent in July

By Fergal O'Brien

July 31 (Bloomberg) -- Inflation in Europe probably accelerated to the fastest pace in more than 16 years in July, increasing pressure on the European Central Bank to raise interest rates even as economic growth slumps.

The inflation rate rose to 4.1 percent from 4 percent in June, according to the median estimate of 36 economists in a Bloomberg News survey. That would be the highest since April 1992. The European Union statistics office in Luxembourg is scheduled to publish its initial estimate of the data at 11 a.m. today.

The ECB, which aims to keep inflation just below 2 percent, raised its key interest rate by a quarter point to 4.25 percent on July 3, a seven-year high. The risk is that higher borrowing costs will exacerbate the economic slowdown. Europe's manufacturing and service industries are contracting and confidence in the economic outlook this month plunged the most since the Sept. 11 terrorist attacks in 2001.

``It's a difficult situation,'' said Stephane Deo, an economist at UBS AG in London. ``The ECB decided to hike in July, focusing on inflation rather than growth. We see another rate hike in September or October, but it's a very close call.''

Investors no longer expect the ECB to raise rates again, Eonia forward contracts show. The yield on the March contract was at 4.32 percent yesterday, down from 4.61 percent on July 21.

`Perfect Storm'

``A perfect storm is engulfing the euro zone, with the economy hit by numerous headwinds to growth including the exchange rate, tighter credit conditions, weaker external demand, a squeeze on real income growth for households and latterly, higher policy rates,'' Ken Wattret, chief euro-region economist at BNP Paribas in London, wrote in a note to clients yesterday. ``We see a much higher probability of a recession.''

The ECB has said Europe's economic fundamentals are sound. In June, it forecast the pace of euro-area expansion will slow to about 1.5 percent in 2009 from 1.8 percent this year and 2.7 percent in 2007.

Euro-region unemployment was probably unchanged at 7.2 percent in June, the lowest since the data series began in 1993, another survey of economists shows. The EU statistics office will also release that report at 11 a.m. today.

``We haven't exhausted our room for maneuver'' on interest rates, ECB council member Klaus Liebscher said in an interview published July 25. ``We're far from giving the all clear on the inflation development.''

Crude oil has risen almost 60 percent in the last 12 months, reaching a record $147.27 a barrel on July 11, while prices for commodities including steel, corn and wheat have also soared.

Second-Round Effects

The ECB wants to prevent companies passing on higher costs and has urged workers not to seek pay increases to compensate for increased living expenses, saying this may unleash a wage-price spiral. Workers at Deutsche Lufthansa AG, Europe's second-biggest airline, are striking in pursuit of a 9.8 percent pay claim.

ArcelorMittal Chief Financial Officer Aditya Mittal yesterday said the company, the world's largest steelmaker, would continue to increase prices this year and next. A European Commission gauge of companies' selling-price expectations rose to a 13-year high in July and Italian wage growth accelerated to 3.6 percent in June, the highest in more than three years.

These ``second-round effects are likely to persist or even intensify in the euro area over the remainder of the year,'' said Gareth Claase, an economist at Royal Bank of Scotland Plc in London. ``Given the ECB's concern about this issue, weak recent activity data does not preclude that the ECB will raise rates again.''

The ECB isn't alone in weighing the risk of stagnating growth against the danger of accelerating inflation. Bank of England policy makers were split three ways in their decision to keep interest rates unchanged this month.

The Swiss central bank has left borrowing costs unchanged since late 2007 as faltering economic growth limits its ability to counter the country's fastest inflation in 15 years.

Federal Reserve Chairman Ben S. Bernanke this month abandoned his June assessment that the threat of an economic downturn had diminished, telling lawmakers that both growth and inflation risks are increasing.

To contact the reporter on this story: Fergal O'Brien in Dublin at fobrien@bloomberg.net.