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,” the commission said.

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.

In time, the EC and ECB will 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 European economy has been afflicted with stagflation, something not seen since the 1970s in the United States.
Surprisingly, the question no longer is: What does Europe do? Instead, 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.

A Bullish View

Few mainstream economists see such a dour outcome for the Fed’s rate-cutting strategy.
Right now, they note, the battered U.S. greenback is poised to post its strongest month against the euro in nearly a year on anticipation that the Fed might be ready to end its rate-slashing campaign.

“If the Fed is not at the end of the easing cycle, it’s near the end,” Jeff Gladstein, global head of foreign-exchange trading at AIG Financial Products (AIG) in Wilton, Conn., told Bloomberg News. “I don’t think the dollar will strengthen aggressively by any stretch, but I do think it’s trying to bottom.”

The dollar has risen 1% against the euro in April and almost 4% against the yen during the same period.

But even those economists temper their optimism. The weak dollar is taking its toll, as commodities (many of which are dollar-denominated) continue to soar. It is likely the Federal Reserve hopes the softening U.S. economy will dampen demand and help to keep inflation in check. But if the current economic contraction does nothing to bring down soaring food and fuel prices - even if Europe doesn’t fade badly - the Fed will have no choice but to reverse course and raise rates to battle inflation.

At least two Federal Reserve Bank presidents are more concerned with inflation than growth. Richard Fisher, president of the Federal Reserve Bank of Dallas, and Charles Plosser, president of the Federal Reserve Bank of Philadelphia, both voted against lowering rates at the last FOMC meeting.

“Really, what we’re dealing with are inflationary expectations,” Fisher said in an interview last week with Fox Business News, The Philadelphia Inquirer reported.

“And what we’re trying to make sure doesn’t get out of control,” he said, “are the expectations of consumers and businesses, the way they price their behavior, the way they conduct their businesses, to begin imputing certain inflationary patterns, because then they’ll be exacerbating inflation, and that’s something certainly none of us wish to see.”

[Editor’s Note: Money Morning Associate Editor Jason Simpkins contributed to this article.]

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