Stagflation stifles Fed, ECB, BoE

By Emily Kaiser

WASHINGTON (Reuters) - The specter of stagflation will likely keep the U.S. Federal Reserve, the European Central Bank, and the Bank of England from changing short term interest rates this week, and their hands may be tied for some time as economic growth slows but inflation remains high.

The $20 per barrel decline in crude oil prices since mid-July has quieted, but not silenced, the anti-inflation rhetoric. All three central banks are on alert for any sign that high fuel and food prices are translating into higher wage demands which could set off an inflationary spiral reminiscent of the 1970s.

But barring another oil price spike like the one that drove prices up by some 50 percent in the previous six months, the ECB and BoE seem content to hold borrowing costs steady through the end of the year. A Reuters poll of economists showed that most expected no change in ECB or BoE interest rates until the first quarter of 2009 at the earliest.

Indeed, the next move in short term interest rates for the ECB and BoE is likely to be down, despite rising inflation rates.

Britain and Spain are both grappling with slumping housing markets, while Germany, Europe's biggest economy, probably contracted in the second quarter.

The scenario may be reversed in the United States, where the Fed has already taken a sharp knife to interest rates in the hope of preventing the housing bust from triggering a deep recession. The Fed has made it clear that it intends to raise interest rates to combat inflation once it is confident that economic growth is reviving.

"We will come out of the financial crisis, but we still have to confront that problem of a changing balance between growth and inflation, or what we like to call stagflation," former Fed Chairman Alan Greenspan said in a CNBC television interview last week.

The Fed's interest rate-setting committee convenes on Tuesday, while the ECB and BoE are due to announce their interest rates decisions on Thursday.

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Through the first year of the global credit market crisis that began in August 2007, the U.S. economy and banking system has endured the brunt of the pain.

The U.S. economy contracted in the final three months of 2007, and grew only modestly in the first half of this year, but there is evidence that European economies are now weakening, and may fare worse than the United States for the rest of the year.

Bruce Kasman, chief economist with JPMorgan in New York, said the Fed's quick interest rate cuts earlier this year helped to cushion the blow for U.S. companies, while European firms are facing higher borrowing costs after the ECB nudged up interest rates in July to try to tamp down inflation.

Kasman said U.S. firms entered 2008 with low expectations, and responded by slashing inventories and cutting jobs. But in Europe, companies continued to hire, and wage pressures built during the first half of the year.

"With corporate adjustments just beginning, the euro area is at risk of significantly underperforming the U.S. and global economy for some quarters to come," he wrote in a note to clients.

That would suggest that the ECB's next move will be to lower interest rates. Economists polled by Reuters think the ECB will cut by a half-percentage point next year, bringing its benchmark rate to 3.75 percent from 4.25 percent.