The Old Monster Is Back

Can you even remember inflation? It was a long time ago, but the soaring prices that ravaged U.S. and European pocketbooks through the 1970s and '80s may be back. Prices are moving again. Economic growth is actually slowing, even threatening a recession in America. Yet the consumer index in the United States has risen at a rate of 3.8 percent this year. The European index climbed 3.4 percent in May, up a fifth from April. The richest, most coddled 600 million citizens on earth now face a rare double threat: lost jobs and higher prices. Inflation and recession both loom over the West.

What's going on? For Europeans and Americans, the unnerving question is why inflation should rear its head at all. Their giant economies have been slowing for a year. The U.S. growth rate has fallen from 5 percent last summer to 1 percent growth this winter and spring. Such slowdowns are supposed to cool off prices, not heat them up. Still, there's no deep mystery. Two shocks that were and are beyond the control of central-bank money managers helped stoke inflation. So did the lagged effects of the long 1990s boom, which may have awakened the latent inflationary bias that lies within all modern economies.

The first big shock was the quadrupling of oil prices by the OPEC cartel, from little more than $10 a barrel to nearly $40, in 1999 and early 2000. These prices, which have settled back to $27, immediately drove up costs of home-heating oil, diesel and gasoline to consumers, but that was just the beginning. Oil is the marginal source of energy supply and the jump in its benchmark price has relentlessly pushed up the prices of all other energy sources. With a delay, the increase is still driving up prices for heavy business users of oil, coal and natural gas--electric-generating utilities; shipping, truck and airline companies, and the world petrochemical industry.

In the United States no less an authority than Alan Greenspan, the chairman of the Federal Reserve, insists that price increases in these few sectors alone account for all of the increase in general inflation over the past 18 months in North America. Businesses outside the inner circle of heavy energy users lack pricing power and have had to pay their higher energy costs out of shrinking profits. Greenspan believes, therefore, that the energy price bulge has mostly moved through the otherwise lean U.S. economy and the inflation rate is headed down. Jim Glassman of J.P. Morgan & Co. agrees, noting that "the U.S. core rate of inflation, excluding food and energy, has been steady at 1.7 percent for two years. Energy and food are heading back there, too." In these circumstances, Greenspan is expected to continue cutting U.S. interest rates to try to prevent a recession, rather than to tighten them to fight an inflation that he thinks is going away.

In Europe, the problem is more complex. The oil shock was compounded last year by a food-price shock created by agricultural-shipment controls imposed after BSE broke out in Britain and then foot-and-mouth disease struck farm animals on both sides of the English Channel. On top of that, Europe is far less integrated economically than the United States. In fast-growing countries like Ireland, Spain, Portugal and the Netherlands, price and wage boosts are now a systematic problem. "They've got general inflation," says Desmond Dinan, an Irish economist at George Mason University in the United States. "The problem is, the European Central Bank's one-size-fits-all monetary policies are good for stodgy giants like Germany and France, but they've let the booming economies run out of control." In an effort to curb runaway consumer spending, Ireland has just passed an extraordinary savings subsidy, under which the government will add one Irish punt (92 U.S. cents) to each four punts put into a special savings account by any Irish resident, up to 200 punts per month.

Across all of Europe, workers are far more heavily unionized than in the United States. (One half of all German workers are in unions versus about 12 percent in the United States.) This means that any general rise in inflation, no matter what the cause, tends to become institutionalized for long periods of time by wage increases imposed in multiyear labor contracts. Europe's core, nonfood, nonenergy inflation has now edged up to 2.1 percent, above the European Central Bank's target ceiling of 2 percent. The ECB has been insisting inflation was going to cool later this year and, until last week's inflation uptick, it was widely expected to cut interest rates again, to cushion the unfolding EU slowdown. Instead, the ECB board met in Dublin a few days later and pointedly kept rates where they were. "I know how those central bankers feel about inflation," says Robert Lawrence, an international economist at Harvard. "I guarantee that they will raise interest rates and risk a recession before they'll let inflation go any higher."