Friday, June 13, 2003

The situation in Europe is getting dicy. As Stephen Roach points out today,
Germany is clearly the weakest link in the chain, yet Europe�s policies are ill-equipped to deal with this serious asymmetrical shock. Although the ECB has now slashed its policy rate to 2.0%, Germany�s 0.8% core inflation rate implies that real short-term rates in Euroland�s biggest economy are still a positive 1.2%. By contrast, with core inflation an estimated 2.4% elsewhere in Euroland, that means real short rates are a negative 0.4% in the non-German portion of the region. That underscores the ultimate inconsistency of Euroland�s monetary policy: Policy is most restrictive in the country that is most vulnerable (Germany) and most stimulative in nations that are in the best relative shape. Such are the pitfalls of an increasingly dysfunctional United States of Europe.
Roach sees deflation now spreading to Switzerland, and "with the rest of Europe in trouble, an extremely open Swiss economy has nowhere to hide."

In another extremely open economy -- the United States vis-a-vis its regions -- the inflation story is also interesting. For example, in the first four months of this year core inflation (CPI minus food and energy) has been running about +3.2% in the Boston area, +2.5% in Los Angeles, +2.3% in the New York metro area, +1.1% in Chicago, +0.9% in Atlanta. For US regions, the core inflation rates vary from a high of +1.8% in the urban Northeast and South to a low of +1.1% in the urban Midwest. The ugly recession-deflation-positive interest rates story in parts of Europe seems most applicable to the US 'rust belt'. Chicago's core CPI was a mere +0.6% in April; Cleveland's was -1.1%. The just-released Fed Beige Book describes the Chicago district's economy as "sluggish," and "manufacturing activity was again weak with few signs of strengthening." For the Cleveland district the picture is "mixed".

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