2nd Round Inflationary Effect Looms – Stark

A broad second round inflationary effect hits the entire euro zone as wages increased recently, Juergen Stark of the European Central Bank said late Tuesday.

Stark said that spiraling inflation risks in the medium term heightened topped by a broad based second round impact.  Stark also added that high prices of energy resulted to accelerating increase in wages and prices.

Stark’s New Dimension

Stark’s assessment gives another dimension to the ECB’s projection of European-wide inflation.  It could send strong warning signals to financial market players who are pinning their hopes against the expected ECB move to further increase interest rates.

ECB feared that firms will arbitrarily raise prices and give generous wage hikes which form part of second round effects.  ECB was concerned that the second round effects would spill over across the board and push general prices upward.  Policy makers have consistently raised the second round effects warning in the past months but none emerged until now.

Stark based his assessment on euro zone labor cost data for the first quarter showing a 2.4% jump which is normally pegged at a consistent 1.4% over the last 10 years.  His assessment came at the heels of significant wage increases on the service sector.

The ECB Dilemma

The current dilemma of the 15-nation zone was the spiraling 4% inflation which was the highest recorded in 16 years.  This was driven by the upward price movement of oil and food which exert strong pressure on the purchasing power of European consumers and business profits.

ECB hoped to dash the inflationary conflagration by raising interest rates to 4.25 percent, up by 0.25 points.  Financial analysts figured out that the measure coupled with the 20% downward movement of oil prices would be enough to solve the looming problem.

Topping all these was the general slow down of the region’s economic performance as record high inflation, high world crude prices, and Euro strength pulled back growth rates.

Data Couldn’t be Wrong

Current economic data releases highlighted the problems as indicators showed general 5-year lows for the entire region.  Data released on Tuesday on the other hand showed German business confidence slumped to a 3-year low, way below the projected expectations for August.

Stark still downplayed recession worries and said that the situation could develop only as patches of weakness while gradual recovery would be the norm.

The events proved difficult for policy makers as they diverged on three fronts.  One camp proposed a deep cut on interest rates to salvage the fragility of the euro zone economy.  The second camp advocated an increase in interest rates to arrest spiraling inflation while a third group cautioned that the economy is unreadable at this point it would be best to leave interest rates alone.