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EU: High Oil Prices, Low Euro, Set Dilemma For European Central Bank

The European Central Bank, which sets monetary policy for the European Union's 11-member eurozone, will soon have to decide whether to raise interest rates amid a maze of conflicting pressures. RFE/RL correspondent Breffni O'Rourke looks at the bank's dilemma.

Prague, 24 August 2000 (RFE/RL) -- When the European Central Bank, or ECB, meets next week (Aug 31) for its first policy session after the summer holidays, it will face a difficult choice about raising interest rates in the EU's 11-nation common currency eurozone.

World oil prices this month soared to their highest point in a decade, reaching nearly $33 a barrel before falling back slightly. This, combined with a weak euro that has fallen in recent days to below 90 U.S. cents, sets a dilemma for the ECB.

That's because high energy prices combined with a weak currency increase pressures for inflation. To counter inflation, the ECB can increase interest rates, so that money is more expensive to borrow and thus eventually cut demand for goods. But at the same time this could stifle economic expansion in the eurozone, which has been picking up this year after a period of stagnation.

Stefan Schneider, a senior research analyst with the Deutsche Bank in Frankfurt, says there is little the ECB can do in the short term to lessen the impact of the oil prices.

"The ECB has set itself a target of below 2 percent [inflation in the eurozone], but at the same time the bank has said that it cannot prevent inflation from temporarily exceeding this target, especially if it is due to an exceptional shock like this oil price surge. I mean, there is nothing monetary policy can do in the short run to prevent this from feeding into inflation. Whether it is critical or not depends crucially on whether there will be spillovers into the domestic part of the price basket. So far core inflation has inched up a little, but is still around 1.3 percent in euroland, so the evidence is not yet clear."

Schneider notes that one factor complicating the bank's decision-making is that it takes time for the inflation to filter through into consumer prices. In other words -- particularly if oil prices do not drop -- inflation in the eurozone may be worse than is yet evident.

On the other hand, he notes that the euro -- weak compared to both the U.S. dollar and the Japanese yen -- is still supporting the continuing surge in eurozone exports, which in turn can help offset the inflationary spiral.

Another factor for the ECB to consider is the unexpected fall for the second consecutive month in German business confidence, as expressed through the leading index of the Munich think-tank known as IFO. This surprise result is blamed for sending the euro down this week, close to its historic low point (eds. the record low was 88.45 U.S. cents).

Adrian Schmidt, a senior currency researcher at Chase Manhattan Bank in London, says it cannot be ruled out that the euro will fall still further -- that's up to the markets to decide. But he also says he does not see the IFO survey result as significant overall.

"In reality. the survey was not really weak, the survey shows some marginal slowdown in production growth from the highs [on the chart],. But we were running at nine-year highs, and we are still very close to nine-year highs in the IFO survey. So I don't think its anything to get excited about."

But the new fluctuations and uncertainties do come at a sensitive time for the people of Denmark. In a month's time, (Sept 28) Danes will be deciding in a referendum whether to drop their national currency, the crown, in favor of the euro. Surveys show that the population is almost evenly divided on the issue, with euro supporters perhaps enjoying a very slight lead.

Greece recently decided in favor of becoming the eurozone's 12th member. Gaining similar acceptance in Denmark for the euro is seen by EU officials as the key to its eventual acceptance also by Sweden and Britain -- the other two member still not in the eurozone. If Danes reject the euro, the opposition to it in Sweden and Britain will be strengthened.

In Britain, meanwhile, a new form of pro-euro pressure is emerging. The strong British pound is making life difficult for local manufacturers, who have to compete against a cheap euro. So one big company with factories in Britain -- Japan's Toyota -- has asked its British parts suppliers to use the euro to settle their accounts. A Toyota spokeswoman linked the move to the desire to cope with currency losses stemming from the strong pound.

Analysts say that if the informal use of the euro in the British economy were to spread, the situation could resemble the informal use of the U.S. dollar in some Latin American countries.