The U.S. Federal Reserve moved for the seventh time in the past six months taking interest rates down to two percent in the United States this week. The central bank, as is customary, put out a statement with the action underlining that financial markets remain under “considerable stress”, credit conditions “tight” and the housing market contraction still underway.

Ben Bernanke and his team at the Fed hope this will be the last of the cuts and that the worst of the credit crisis has past -- don’t be too certain about that. This is what concerns central bank counterparts in the Middle East, especially those in the Gulf States.

Watching with anxiety what is transpiring in the U.S. economy and to a lesser extent what has crossed the Atlantic to Britain, Gulf Cooperation Countries, minus Kuwait, have to follow suit due to their dollar pegs. They did and they too hope the storm front has passed – again don’t be too certain about that as well.

The problem, as we have talked about in this column, is quite different in the Gulf and it became more difficult this week in the region’s largest economy, Saudi Arabia. Inflation in the Kingdom hit a near 30 year high of 9.6 percent. The cost of rents, fuel and water surged 15.8 percent in March; other day-to-day staples saw double digit gains as well. Rents went up nearly 17 percent at the start of the year.

The United Arab Emirates, which is traditionally slow in releasing these figures, officially is seeing an inflation rate of 9.3 percent, but that goes back a half year. Other fast-growing, energy rich states are facing similar challenges. The real issue is what to do about it.

Finding an answer is not easy. For one, interest rates should be going up, not down. Number two, wages cannot keep pace with inflation, but leaders like Hosni Mubarak of Egypt know when the heat is on. He took what was an already high pay increase for civil servants of 15 percent and doubled it. The region’s most populous country is running a near double digit budget deficit, so he actions won’t be welcomed by foreign investors nor the finance ministry for that matter. And to round out the list, money supply will continue to surge as OPEC export related earnings this year surge past the $1 trillion mark.

Fuelling the Titanic

The real challenge with inflation, as central bankers and economists know, is that when it accelerates it is very difficult to slow it down. For purposes of an easy analogy, this is not a nimble racing boat, but a high speed Titanic. The real danger at hand is the threat inflation poses for the economic development cycle now underway in the Middle East. On our program we often talk about an Arab Renaissance, that growth this year, despite the downturn in the G8 countries should still be above 6 percent. That is true, but it won’t mean much if that growth is eaten away by skyrocketing prices.

The other issue is keeping workers in all those “castles in the sand” being constructed. The number is staggering; $3 trillion is either at work already or on the drawing boards. It will be very difficult to sustain those mega-projects if one cannot attract builders and very importantly laborers to get through the summer heat so they can send monies home to India, Bangladesh, Sri Lanka or Vietnam.

For Dubai and its second wave of development this, of course, will need to be addressed. But I am thinking more about Saudi Arabia in which one of the seven economic cities currently gathering momentum. The other six hold the key to the Kingdom’s future for the next generation to come.

Food for All

The region, minus the North African states, is overly dependent on imports, especially food. Gulf countries are paying for those imports with a weak dollar, which is down 35 percent against the euro in three years. The European Union is the number one market for those goods. This is where the loyalty to the dollar gets very pricey. Leaders from the United Nations and the World Bank held an emergency meeting in Switzerland this week and set up a food crisis task force aimed at helping the poorest countries deal with escalating prices.

It is hard to argue that countries seeing record oil revenues are suffering as badly as those say in Sub-Sahara Africa – that is certainly not the case – but rising prices are a real problem and will continue to be so.

Posted by CNN's John Defterios: 1:08 PM

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