January 11, 2008

Europe can be reached by the US credit crisis

Can Europe's economy stay on track even if the United States goes off the rails? This old question is being asked with new urgency across the Continent, after a startling divergence this week in how the European Central Bank and the Federal Reserve are reading the economic tea leaves. The answer is that Europe is not as insulated from America's woes as many Europeans would like to believe. They question why, at such a fragile moment, the European Central Bank is warning that it might raise interest rates. The Federal Reserve signaled it would cut rates further to try to ward off a recession.

The European Central Bank still did not believe that the credit crisis originating in the U.S. mortgage market posed a grave risk to Europe's underlying economic prospects. The bank was threatening a rate increase when it should be preparing for a rate cut. The simplest explanation for the European Central Bank's hawkish demeanor is its inflation-fighting mandate. The bank's president, Jean-Claude Trichet, has warned labor unions that they should not use Europe's inflation rate of 3.1 percent as a pretext to demand steep wage increases.

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