Euro hawks feast on dollar

The dollar took another drubbing Thursday as inflation hawks spread their wings in Europe.

The euro climbed near $1.40, putting it up more than 4% on the year (see chart, right), after European Central Bank chief Jean-Claude Trichet said the ECB may raise its benchmark interest rate as early as next month.

Is the sky the limit?

“Risks to the medium-term outlook for price developments are on the upside,” Trichet said. “They relate, in particular, to higher than assumed increases in energy and non-energy commodity prices.”

The ECB kept its policy rate unchanged as expected at 1%, but Trichet warned that the bank is ready to change that policy in a “firm and timely manner.”

The comments sent foreign exchange traders rushing into the euro on the expectation that the interest-rate differences between the euro and the dollar will widen. Fed chief Ben Bernanke has made it clear that the U.S. central bank is in no hurry to raise its overnight bank lending rate from the current range of 0% to 0.25%.

Trichet’s remarks come as policymakers struggle to balance a weak recovery in rich Western economies with a surge in commodity prices, notably for food and fuel, that is pinching consumers’ spending power and threatens to raise inflation expectations. Oil priced in London is fetching $120 a barrel, which is why gasoline prices here are headed toward $4.

Central bankers have been on the watch for signs that higher commodity prices are translating into higher prices for finished goods and demands by workers for higher wages.

Chris Williamson, chief economist at data provider Markit, said the strength in purchasing manager indexes across the Continent this year support the case for a rate hike. “In the absence of any further jump in oil prices or any worsening of the debt crisis in the euro area’s periphery, an early hike in rates looks to be on the cards,” he said.

But skeptics of the government-led recovery in Europe and the United States say the euro could be headed for a fall as European fiscal and banking problems rear their head again. They expect the euro to pull back sharply against the dollar later this year as political discord over European bailouts re-emerges and European growth slows.

In other words, get ready for a re-run of 2008 — but without Jimmy Cayne and Dick Fuld throwing gasoline on the fire.

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