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We are all probably aware that inflation leads to an erosion in the value of a currency. Then how can inflation in the Euro zone prop the Euro! The seeming conflict has a short term vs. long term connotation. Inflation may not impact the value of a currency in the short run. However, sustained inflation can lead to depreciation in the currency value in the medium to long term. This is exactly what the European Central Bank (ECB) does not want and it proposes to use the interest rate lever to manage inflation. But, the ECB, just like the US Fed is faced by a dilemma. Economic growth is slowing down, which requires a lowering of interest rates, but rising inflation is not permitting the ECB to lower interest rates.

A slowing economy, in the long term, would also lead to depreciation in the Euro. Thus, the ECB needs to choose between controlling inflation now and worrying about growth later and stimulating growth now and worrying about inflation later. The US Fed appears to have taken the latter path, whereby it lowered interest rates in quick succession to spur growth and did not worry about inflation as much.

It appears that the Europeans are more conservative and are likely to fight inflation first and worry about growth later. Also, the conditions in the economic woes of the US were much worse as compared to Europe as the US was hit by the sub prime crisis. But analyzing the divergent approach being taken by the two economies of similar strength will provide observers a good case study to examine which route works better.

Economic conditions in the Euro zone

Inflation in the Euro zone surged to 3.6% in May as against the 3.3% rate in April. Since the ECB has set a target rate of 2% for inflation, the present rate is considered high and dampens any hope of a lowering of interest rates. Annual inflation rate in Italy rose to 3.6% and inflation in Spain was even higher at 4.7%. The data received from Belgium and France was equally discouraging, with annual inflation rates jumping to 5.21% and 5.4% respectively. Due to the given inflationary pressures being face by the Euro zone it is widely expected that the ECB will hold its benchmark interest rate at 4%.

Economic growth in the Euro zone has not been promising and could have been best tackled by a booster injection of interest rate cut. In Germany, the Euro zone’s biggest economy, retail sales feel in April 3.3% on the back of a 3.8% decline in March as per Bundesbank figures. According to the European Commission, overall growth in the Euro zone is expected to slow down to 1.7% in 2008 from the 2.6% in 2007.

Signs for the Euro

If the Europeans get it right, holding interest rates steady may help contain inflation and at the same time keep the Euro strong. Once the inflationary pressures start to abate, the ECB can start lowering interest rates to bolster economic growth. This could happen in 2009. This move may weaken the Euro marginally. The longer terms outlook for the Euro beyond this point will depend upon how quickly the European economy responds to rate cuts and gets into the growth mode. Once the economy start growing, the Euro is likely to stabilize and head north.