The threat of stagflation loomed larger in Europe on Tuesday as German investor sentiment slid to a record low as the dollar charted a fresh trough versus the euro. Asia was equally rattled, with bank shares tumbling on reports about regional exposure to troubled top US mortgage lenders Freddie Mac and Fannie Mae. And the Bank of Japan, after leaving interest rates on hold at 0.5 percent, downgraded its growth forecasts, warning high energy costs were slowing the world's second largest economy. The gloomy data and renewed doubts over the solidity of the world's banks, eclipsed Monday's optimism about a US government plan to help out home financiers Fannie and Freddie. The US currency fell to $1.6038 to the euro, its lowest ever level. Tuesday's figures encapsulated the conundrum facing central banks worldwide - should they cut interest rates to support growth as the Federal Reserve has, or tighten policy to curb inflation, the route the European Central Bank has taken. Many experts are now forecasting technical recessions at least, defined as two successive quarters of contraction. The ZEW research institute's gauge of German economic sentiment fell to -63.9 in July from -52.4 in June, the lowest since the survey began. “The German economy is very likely to have shrunk in the second quarter and it cannot be expected to rebound any time soon,” said Carsten Brzeski, an economist at ING. High oil prices, the strong euro, the crisis in the United States, an ECB rate rise and weak domestic demand would probably hurt German firms over the next six months, the ZEW said. Unexpected falls in German, French and Italian industrial production, reported last week, had already fuelled fears of European recession. But with oil and other commodity prices having rocketed, inflation has taken off, raising the spectre of 1970s-style stagflation. BOJ Governor Masaaki Shirakawa said Japan was not suffering stagflation although it faced a combination of slowing growth - now forecast at just 1.2 percent for this year - and rising inflation. But a BOJ statement said: “Economic growth is slowing further, reflecting weaker growth in business fixed-investment and private consumption against the backdrop of high energy and materials prices.” That suggested the central bank had changed its view from last month, when it said consumption was firm. The ECB, which hiked rates earlier this month, faces the same dilemma. Euro zone inflation hit 4.0 percent in June while economic growth in the bloc looks set to slow sharply. The central bank targets price growth of close to but below 2.0 percent. Its economy is slowing but gross domestic product still grew 10.4 percent year-on-year in the first half of 2008, two official sources familiar with the data said on Tuesday. But even there, some researchers and officials believe the time has come for the authorities to relax policy to avert the risk of a sharper slowdown over coming months. In the United States, where the implosion of the subprime mortgage market last year first rocked the global economy, US producer price inflation data are due at 1230 GMT. Federal Reserve Chairman Ben Bernanke testifies to Congress from 1400 GMT, and will spell out plans to assist Freddie Mac and Fannie Mae, which own or guarantee $5 trillion of debt, close to half the value of all US mortgages. Foreign central banks, mostly in Asia, hold $979 billion of the bonds and mortgage-backed bonds sold by the agencies, hence the wobbles suffered by Asian markets on Tuesday.
