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Five nations lowered interest rates last week in step with the Federal Reserve to keep their links to the U.S. currency even as inflation accelerates. When Saudi Arabia left rates unchanged after the Fed’s Sept. 18 reduction, the riyal rose to a 20-year high.

“A lack of action on exchange-rate policy continues to fuel inflation, driving wage demands, which in turn fuel inflation,” a Merrill team including currency strategist Emma Lawson wrote in an e-mailed note today. “Revaluation and a move to a basket could break this vicious cycle.”

Inflation accelerated to records in all six of the Gulf Cooperation Council, or GCC, states last year as the oil-rich nations sought to preserve their dollar links. The regional average was 6.3 percent in 2007, compared with 0.3 percent in 2001, according to Merrill, the world’s largest brokerage.

The Fed cut its target rate for overnight bank lending by 1.25 percentage points in January to prevent the housing slump from pushing the U.S. economy into a recession. The U.S. Dollar Index traded on ICE Futures in New York, which tracks the currency against six major counterparts, dropped 0.7 percent last week to 75.45. It was at 74.48 on Nov. 23, the weakest level since the gauge started in 1973.

“It’s going to be very difficult for central banks in the region to have adequate control of monetary policy, and hence inflation, when the Fed is slashing rates left, right and centre and the dollar is slumping,” Steven Barrow, chief currency strategist in London at Bears Stearns, the fifth-largest U.S. securities firm, wrote in a client note yesterday.

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Speculation of a Gulf-wide revaluation is rising before a meeting between Saudi Arabia’s advisory council, the Shura, the finance ministry and the central bank, according to Barrow, who said the largest Arab economy is blocking other states from dropping their dollar pegs. The meeting will be held on Feb. 17, Arab News reported.

“The authorities do not have to act on recommendations from the council and, of course, the council might not even recommend any currency change,” Barrow wrote.

Saudi Arabia, the U.A.E., Qatar and Bahrain cut their benchmark rates for deposits by half a percentage point to 3 percent on Jan. 31, while Kuwait lowered its repo rate by the same amount to 3.5 percent. Oman cut its repo rate 0.18 percentage point to 4.14 percent today, Dow Jones reported.

“Central banks can take other measures to try to limit the damage, such as raising reserve requirements, but we are skeptical that this works and we are also concerned that such tactics can adversely affect the banking sector,” Barrow said.