German inflation rate (y-y change) is up to 1.9% in January 2011, the highest level in two years. Inflation in other European core economies, such as the UK and France, also picked up significantly by the end of 2010. December inflation (y-y change) in France is 1.8% and December inflation (y-y change) in the UK is 3.7%.
Fiscal austerity measures for European countries in the middle of the sovereign debt crisis, such as PIIGS countries, are supposed to cut the public spending, reduce the labor cost, and make their economies more competitive. However, inflation in PIIGS countries rose even faster than these core economies in Europe, partly due to the consumption tax increases. These faster-rising inflation problems actually push business costs in PIIGS countries even higher, compared to core European economies. Portugal inflation rate (y-y change) increased from 0.1% from January 2010 to 2.5% in December. Spain inflation rate (y-y change) increased from 1.03% from January 2010 to 2.99% in December.
Overall Eurozone inflation hit 2.2% in December, which compelled European Central Bank (ECB) President Jean-Claude Trichet to give a hawkish comment on inflation recently. However, ECB really does not have a lot of options. Any rate raise obviously will further dampen the economic growth in PIIGS countries and negatively affect their fiscal revenues. These countries already depend on ECB funding mechanism to support their public finance. Their banking systems will be under more pressure if ECB ever lifts the interest rate to increase the borrowing costs.
So far, the fear of an immediate sovereign bailout for the rest of PIIGS countries (Portugal, Italy, and Spain) has been calmed since bond auctions at the beginning of the 2011 went pretty well. However, the yields of PIIGS government bonds were rising again in the past few days. The spiking January inflation in Germany is a warning signal. Inflation is likely to rise sharply in countries like Spain and Portugal as well. The rising bond yields and increased inflation expectation will likely to push the yields of PIIGS government bond sales even higher next week. The spiking borrowing costs will certainly put pressure back on the indebted PIIGS countries. Right now, investors are focusing on the political turmoil in Egypt and uncertainty in the oil market. Once the attention is shifted away from the event in the Mideast, the worry about the financing cost of PIIGS countries could return and contribute to the weakness in EUR.
Spain 10yr Bond Yield
Portugal 10yr Bond Yield