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Slaying the inflationary dragon: TIE's exclusive interview with Bundesbank President Axel Weber.

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TIE: What is your view of the risks of inflation versus economic growth in both Germany and the Eurozone? The Eurozone as a whole is experiencing inflation above 3 percent and some of the confidence indicators are mixed.

Weber: On inflation it's true that recent figures have tended up quite a bit, and in Germany we saw inflation at 3.1 percent for the consumer price index, and at 3.3 percent for the harmonized European measure in November. These rates have caused some discomfort because people in Germany haven't seen inflation that high since 1994. However, you have to take into account that roughly haft of German average inflation in 2007--that is, 1.5 percentage points--is caused by the recent VAT increase, so it's a one-time effect. In addition, there are some base effects due to oil and food price increases from last year that have led to higher inflation. Our expectation is that inflation in Germany and in the Eurozone will start moderating after the turn of the year, but it will take some time for it to fall below 2 percent. Thus, inflation is likely to be above 2 percent on average in 2008 and it may fall below 2 percent again only toward the end of 2008.

With this kind of hump-shaped figure for short-term inflation, which can also be observed in the Eurozone as a whole, it is important to note that part of the spike in inflation is transitory. Nevertheless, there is also some underlying momentum in core inflation, now slightly above 2 percent.

In addition, the risks over the projection horizon of two to three years are to the upside and include the risk of a new round of oil price increases (in particular with a view to geopolitical risks and continuing high international demand for energy) as well as tense food markets. The hump-shaped figure for inflation corresponds to a short-term dip in output growth rates which are then likely to increase again over the course of next year and into 2009.

So we have a U-shaped output profile over the medium term, with growth rates being somewhat more moderate in the fourth quarter of 2007 and possibly in the first half of 2008 than they will be in the medium term. Through 2008 and 2009, the Eurozone is likely to grow slightly below potential and output growth in Germany is expected to moderate somewhat towards potential growth over the next two years on average.

For me, the medium-term outlook is that the European and German economies are still on a solid footing. The confidence indicators suggest that growth momentum is somewhat fading but still at a level which is consistent with our long-term growth potential.

TIE: The Eurozone economic outlook has been confusing lately.

Weber: Business and consumer sentiment indicators in the Eurozone are still at relatively high historical levels. But the momentum has gone down. It's simply a sign that with higher inflation and in particular higher oil prices, the way forward is not viewed as optimistically anymore. Thus, the euro area economy will lose some of its momentum. But it will not weaken markedly.

TIE: As the Eurozone expands to include the Eastern European economies, do you see them as more tolerant of a higher inflation rate? Do you want to factor in any change in the European Central Bank's forecast?

Weber: No, I am sure that our medium-term objective will remain the same. We look at the Harmonized Index of Consumer Prices (HICP) headline inflation rate for the medium term. We don't take out on a systematic basis the effect of energy prices. We aim at medium-term inflation on average below but close to 2 percent.

Taking into account recent experiences of the European convergence process, new EU member countries with higher inflation than the Eurozone average partly owe their inflation performance to convergence-related higher growth rates. They should manage their convergence process before entering into monetary union so as to reach a level of economic development and a soundness of economic and financial policies that enable them to cope with the challenges of the common European currency.

I don't think there will be a change in the Eurosystem's attitude towards inflation, simply because the entire convergence process is based on the philosophy that a country must move in the direction of the Eurozone's best three...

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