Fears of inflation rising over 7% as oil prices increase

Oil prices have surged 11 per cent on concern that escalating violence in the Middle East could disrupt supplies, prompting fears that inflation here could rise above 7 per cent. As the violence intensified yesterday the oil markets were thrown into panic, with concern triggered by the fact that a third of global oil supplies come from the region. World stock markets fell sharply on the news, which will put further pressure on the severely weakened euro. European Central Bank president Mr Wim Duisenberg said yesterday recent intervention on foreign exchange markets demonstrated how serious it was about preventing an "excessive depreciation" of the euro.

The central bank head said the ECB and other central banks had acted to prevent the currency's slide from fuelling domestic inflation and possibly damaging global growth. "We are ready to back up our words with deeds," he said in a speech to academics and business executives in London.

The ECB is likely to increase interest rates again in an effort to curb inflationary pressures, according to Mr John Beggs, chief economist at AIB.

In its monthly bulletin released last night, the ECB highlighted its concern that inflationary expectations and wage rises needed to be controlled. Even before yesterday's price surge it warned that if energy prices did not decline significantly it would take some time before inflation returned to below 2 per cent.

Mr Beggs pointed out that the ECB would increase rates when faced with higher oil prices as they immediately fed into consumer prices. That is likely to be negative for the currency.

However, the US Federal Reserve is likely to take a longer-term view that high oil prices will dampen economic activity and ease inflationary pressures and thus not raise rates.

A combination of rapidly rising oil prices, a still weak euro and likely mortgage rate rises would mean inflation would rise well above the 7 per cent peak currently forecast, Mr Beggs warned. "This risks bringing the pay round into even more disarray than it is at the moment."

According to Mr Beggs, the correct response from the authorities is now critical. "The ECB should recognise that high oil prices dampen growth and they should avoid rate rises. The authorities here should make sure the Budget is less expansionary than anticipated and call a special session of social partners to accept that you cannot compensate for a loss of income to OPEC and other oil producers."

Yesterday the euro closed at $0.8648, below the level where the ECB last intervened to buy the currency.