Why Europe will save us from $5 gas

The unwillingness of Europe's central banks to cut rates will eventually lead to a continental slowdown, a stronger dollar and lower oil prices.

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By Paul R. La Monica, CNNMoney.com editor at large

The dollar has actually strenghtened against a basket of global currencies in recent months even as oil prices surge...
...and gold prices have tumbled as well, which could be a sign that other commodity prices (including oil) may soon head lower.
When it comes to the economy, I feel:
  • The worst is over
  • It will be up and down
  • It's going to get worse

NEW YORK (CNNMoney.com) -- With oil prices gushing above $126 a barrel, it's tempting to blame Europe for this inflationary mess.

Both the European Central Bank and Bank of England, following their inflation-fighting mandates, left interest rates alone this week.

The fact that the ECB and BOE have held the line on rates, while the U.S. Federal Reserve has been on a cutting binge, has made the commodities problems worse by contributing to the stronger euro and weaker dollar. Remember: Oil is traded in dollars.

"Currently, the focus is inflation inflation inflation for Europe despite their strong currencies. And it's a self-perpetuating cycle. Oil goes up. The ECB and BOE hold firm. The dollar weakens and the oil exporters want higher prices," said Kurt Karl, chief U.S. economist for Swiss Re.

But a funny - and, dare I say, encouraging - thing has happened in recent weeks. Even though oil prices have surged to new highs, the dollar has actually strengthened. What's more, the price of gold, another key inflation gauge, has fallen dramatically.

With that in mind, there may be something to be said for the notion that speculators aren't really the main culprit driving oil prices higher. Instead, demand outside the United States is getting stronger.

"Supply is not coming on fast enough to meet demand, particularly from Asia," said Karl.

Indeed, there are no signs that Asian demand will peak anytime soon. Healthy demand from Europe has also contributed to oil's rise.

The good news for U.S. consumers is that because the ECB and BOE have yet to lower rates, European economies - and hence demand for oil - will eventually weaken. That means that oil prices, at best, should edge down and, at worst, stabilize instead of spiking dramatically higher.

The Federal Reserve has cut interest rates seven times since September to deal with the effects of the subprime mortgage meltdown and credit crunch. But the ECB and BOE have not responded accordingly. That won't last much longer though, and that should lead to a stronger dollar, weaker demand for oil from Europe and lower oil prices.

"The ECB and BOE are holding monetary policy tighter than the Fed. That should have a restraining effect on broad economic performance in Europe and energy demand," said Keith Hembre, chief economist with First American Funds. "Ultimately, they will both cut rates."

Karl agrees. He thinks that by the end of the year, Europe's economy will weaken and that could lead to as much as a half-point in cuts by the BOE and ECB.

Of course, the Fed has to help out as well. Barring a more severe deterioration in the housing market, the onus on the Fed will be to keep the dollar from slumping further and to hold commodity prices in check.

So the Fed will need to, at a bare minimum, hold interest rates steady at 2% for the foreseeable future. Ben Bernanke and Co. may even need to start considering when it's time to raise rates again.

That's what Wall Street seems to think. According to the widely-watched federal funds futures listed on the Chicago Board of Trade, investors are pricing in an almost near-certainty that the Fed will hike rates by a quarter-point by early 2009.

To be sure, none of this will lead to immediately lower prices at the gas pump as the summer driving season approaches. Unfortunately, we might all have to get used to $4 a gallon gas.

But as long as Europe's central banks lower rates to deal with their own looming slowdowns and the Fed isn't forced to cut rates again, then that should spell relief for U.S. consumers on the inflation front by this time next year.

In other words, even though it's fashionable to predict higher and higher prices for crude and gas, a stronger dollar may save us from $200 oil and $5 at the pump.

Issue #1 - America's Money: All this week at noon ET, CNN explains how the weakening economy affects you. Full coverage.

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