Even with a bit of a rebound, of late, the dollar is down more than 7.3% against the euro in the past six months, 12.35% in the past 12 months and nearly 28% in the last 54 months. The decline in the greenback has helped fuel inflation - which, in turn, has fueled the massive run-up in the cost of food- and energy-related commodities.

Take oil. Because crude oil is priced in dollars - in fact, they’re referred to as “petrodollars” - a consistent drop in the value of the dollar almost automatically translates into an escalation in oil prices, since members of the Organization of the Petroleum Exporting Countries want to keep petroleum prices steady.

Crude oil hit a new record of more than $119 a barrel this week. On Sept. 18 - the day before the Fed started cutting interest rates - oil was trading at $81.52 a barrel. By the end of the year, oil prices had escalated to $96 a barrel. That means that crude-oil prices have soared 46% since the central bank started cutting interest rates.

At the same time, however, the cheap dollar has made U.S. exports very competitive abroad. Indeed, for foreign buyers of such big-ticket products as Boeing Co. (BA) jetliners, the plunging dollar has served as a global blue-light special. Boeing’s bureaucratic arch-rival, Airbus SAS, hasn’t been able to compete, and a week ago was actually forced to raise prices on two of its commercial jets - citing rising steel prices and a falling dollar as the two key causes.

Foreign Fury

On Sunday, French Economy Minister Christine Lagarde said the gap between the U.S. and Eurozone interest rates was way too large, and called for a change in interest-rate policies - either by the Fed or the European Central Bank (ECB).

While the Fed has been slashing rates to stave off a recession - largely ignoring inflationary pressures in the process - the ECB has kept rates high to combat inflation, even though that strategy is pushing Europe into an undesirable slowdown.

“We are in a delicate situation where we have, on the one hand, an American Federal (Reserve) which has a policy of very low rates and a European Central Bank which has maintained high interest rates,” Lagarde told LCI Television and RTL Radio, the global wire service Reuters reported. “The differential in interest between the two, it seems to me, is a little too big at the moment.”

Paris has long been a vocal critic of what French President Nicolas Sarkozy has termed the ECB’s overly narrow focus on fighting inflation. But Sarkozy and Co. have been criticized by both Germany and the ECB for attempting to meddle in the business of a supposedly “independent” central bank.

With Eurozone inflation running at about 3.6% - its highest rate since the measure for that portion of the European market began in 1997, the European Central Bank (ECB) has left its key refinancing interest rate unchanged at 4.0%, despite some very definite signs that Eurozone growth is slowing.

The European Commission, the executive branch of the European Union, said Monday that Eurozone growth would continue to erode throughout 2008 and 2009. The EC said the combined economic growth rate for the 15 countries that use the euro would slow to 1.7% this year and 1.5% next year. The EC has cut its growth projections twice since November.

But here’s perhaps the biggest wild card: Inflation will climb to 3.2% this year, more than it previously forecast and well outside the group’s comfort zone of just under 2%. And it’s not expected to throttle back until late next year. For that reason, the commission remains focused on inflation, which it considers “the main problem that we have to face in the short term.”

According to the EC, “the recent sharp rises in food and energy prices have depressed households’ purchasing power and consumer spending in the last quarter of 2007 and are expected to continue to do so during most of 2008.”

That may have to change. And here’s why.

Another cut in the U.S. Fed Funds rate will cause the dollar to skid and inflation to escalate still more, giving U.S. exporters an even bigger advantage over European rivals.

Dollar-denominated commodities such as oil, metals and food will continue to escalate in price. Initially, it will appear only as if U.S. exporters are just gaining an ever-larger advantage over their counterparts in Europe. European corporate profits - and stock prices - will start to feel the squeeze.

Sarkozy and Co. will step up their lobbying efforts against the EC and ECB - pushing for the rate reductions needed to restore parity with Europe’s economic rival across the Atlantic - making the French president even less popular.

Two scenarios are possible.

In one, the EC and ECB will suddenly realize that this is not a temporary competitive disadvantage, but instead is a full-fledged slowdown. Even worse, it’s not a conventional slowdown, for Europe’s growth is declining steeply, even though inflation is escalating.

In short, the U.S. economy will have exported “stagflation” into the European economy, a syndrome not seen since the 1970s in the United States.

If that happens, the question won’t be: What does Europe do? It will be: How can the U.S. central bank help us?

If the ECB slashes rates, it will boost growth. But it will also further fuel inflation.

So it’s possible that the first major moves will fall to the U.S. central bank, which will have to start boosting rates to draw the over-abundant liquidity from the financial markets and tame inflation.

But the process could take some time.

In the second possible scenario, the ECB decides that the ongoing rate differential is economically unhealthy, and that stronger growth with some heightened inflation is a much better option than a no-growth malaise and a currency/interest rate climate that has left Eurozone businesses totally vulnerable to U.S. exporters.

In that case, the ECB starts to slash rates, leveling the playing field and perhaps blunting a U.S. recovery. That could force the U.S. central bank to move anew.

By Jennifer Yousfi
And William Patalon III
Money Morning Editors

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Pages: 1 2