Global Economics

Fed Rate Cut Could Hammer Europe


In contrast, the European Central Bank may hike rates to battle inflation, which would boost the euro and severely slow exports

Economic growth in the United States will, in the short term, slow down. That, at least, is the future seen in the US Federal Reserve's crystal ball. The consequences of that forecast became clear on Wednesday: The central bank cut short-term lending rates by a quarter of a percentage point to 4.5 percent. The idea is to nip any possible recession in the bud.

The decision by Chairman Ben Bernanke and his board of governors was far from unexpected. Economists across the US had been anticipating the move prior to the official announcement. In the same breath, the Fed also dropped the discount rate -- which governs rates charged to banks borrowing from the Fed -- by 0.25 percent to 5 percent.

"Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance," the Fed said in a statement on its Web site. "However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction."

Inflation on the Way

It didn't take long for the results to make themselves felt. Anticipation of the Fed's move had already driven the price of the euro up -- and soon after the announcement, the euro reached a new record price of $1.45 before sliding back slightly. Oil prices likewise shot up, partially due to anticipation stemming from the interest rate cut that the US economy would continue to grow. And gold prices have likewise hit $800 per ounce, a price not seen since 1980.

The short-term rate cut was not the first this autumn. In September, the Fed cut the rate by 50 basis points -- 0.5 percent -- in response to the sub-prime crisis on the US housing market. It was the first reduction in more than four years. The move made money cheaper, thus making investments more attractive and boosting the economy. But it can also fuel higher prices, meaning inflation can quickly rear its ugly head.

The Federal Reserve Bank, though, elected to go ahead anyway. "Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation," the Fed statement said. "The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth."

One thing the statement doesn't mention, however, is the massive influence Wednesday's decision will have on trans-Atlantic trade. The lower interest rates are in the US, the more attractive assets become elsewhere -- particularly in the euro-zone.

Europe Going in Opposite Direction

The best indicator for this phenomenon, of course, is the exchange rate. In expectation of the Fed's announcement, the euro shot to yet another record high on Wednesday afternoon, reaching $1.45032 for each euro before sliding back slightly on Thursday to $1.4425.

But despite the drop, the flow of capital in Europe's direction could soon become even greater. The European Central Bank (ECB) will also be facing an interest-rate decision soon. But observers expect Europeans to go in the opposite direction. A rate rise may be in the offing.

The reason is simple. Whereas the Fed always has one eye on economic growth, the ECB's raison d'être is controlling inflation. And inflation in Europe has recently increased dramatically. The ECB will likely steer against that trend, making an interest rate hike the logical conclusion. The euro, as a result, will likely continue to rise against the dollar.

Just how large the inflation problem in the euro-zone has become is apparent from numbers released by the European statistics office Eurostat on Wednesday. Economists there estimate that prices have risen by 2.6 percent in October, against rises of 1.7 percent and 2.1 percent in August and September respectively. The stated goal of the ECB is to keep inflation below 2 percent. The pressure to do something is growing.

Powering the growing inflation are rising energy costs. The price of a barrel of oil this week skyrocketed by $6 in just 24 hours to hit a record high of $96 per barrel on Thursday before dropping slightly. Oil prices rose on an announcement by the US Department of Energy that American oil reserves were lower than expected. Experts now believe that prices of $100 per barrel are not out of the question. Prices for grain and other foodstuffs are also rising around the world, as are costs for raw materials.

Export Risks

The US economy has so far managed to defy this development, with the Department of Commerce reporting that the American economy grew by 3.9 percent in the third quarter after an expansion of 3.8 percent in the second -- though a report on slower consumer spending caused the Dow Jones industrial average to plunge by 200 points in early trading on Thursday.

Still, growth of just under 4 percent is solid -- and comes primarily thanks to strong exports. US products can be had cheaply on the world market these days.

In Europe, though, the situation is a completely different one. The stronger the euro, the more expensive European goods become. "The weak dollar is not a good thing," says Kay Mayland, head of Germany-based SMS Demag, which sells metal-working equipment the world over. Many other managers and investors from across the European continent are likewise becoming impatient. Should the euro climb to $1.50, analysts say, exporters will likely experience a drastic slowdown in sales.

For Germany -- Europe's largest economy -- the consequences could be horrendous. Much of the country's economy, after all, is based on exports.

Provided by Spiegel Online—Read the latest from Europe's largest newsmagazine

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