Central banks working for one big union

For Irish mortgage holders, the next 12 months hold the promise of a fall in interest rates, and indeed, the interest rate argument has been central to the economic case for Ireland's membership of EMU. Right now, German interest rates are 3.75 per cent against 6.25 per cent in Ireland - so can we look forward to a 2.5 per cent fall in mortgage costs? Unfortunately, the answer is "no", and it is possible that the ultimate fall in rates will be minimal, possibly only 0.5 per cent or equivalent to £15 per month on a £50,000 mortgage. The problem is two-fold - interest rates will rise in Germany for domestic reasons over the next year and European rates will be pushed higher to ensure that the euro is a credible currency with low inflation, when it materialises.

Generally, interest rates move up and down with economic activity - when the economy is depressed, rates are down and in a booming economy interest rates rise, partly as a natural phenomenon (individuals and firms look to borrow money) and partly as a policy move by central banks anxious to limit inflation.

So the reason interest rates in Germany and continental Europe are low is nothing to do with EMU and everything to do with the fact that growth in these economies has been very low or negligible for the last few years.

This is now changing and activity is picking up, a fact acknowledged by European Commission in its latest forecasts for 1998. So in the normal course of events, Germany would be raising interest rates anyway in order to pre-empt any inflation appearing in a year. However, the fact that a European Central Bank will set euro interest rates in 1999 adds a new and unique dimension - the new bank will inherit a European inflation rate which will be determined by interest rates now, given the time-lag between changes in monetary policy and its effects on the economy.

So Bundesbank and the other European Central Banks appear to have agreed to raise interest rates over the next nine months in order to ensure that the new euro is not born against a background of high and accelerating inflation.

Consequently, the financial markets now expect German interest rates to have reached 5 per cent by the end of 1998, implying that Irish rates will also be at that level.

Mortgage rates trade about 1.25 percentage points to 1.5 percentage points above money market interest rates, so 5 per cent cash rates would be consistent with a mortgage rate of 6.25 per cent to 6.5 per cent, against average mortgage rates of 7.25 per cent to 7.5 per cent at present. Yet, German rates may well be higher, thus reducing the likely fall in Irish rates. This is because some EMU members will introduce rate cuts, regardless of whether they are appropriate on domestic grounds. This will push up inflation in these countries, including Ireland, although the Irish economy accounts for only one per cent of the euro market, so it has no great significance on the latter.

However, Italy accounts for 21 per cent of the euro (assuming 11 members join) and the periphery as a whole (Ireland, Italy, Spain, Portugal and Finland) accounts for 36 per cent. So an inflationary interest rate cut in the periphery would push euro inflation quantifiably higher and for that reason European central banks may want to minimise such cuts.

The bottom line is that German rates may be 5.5 per cent or higher, rather than 5 per cent and in that case Irish mortgage rates would settle at 6.75 per cent or 7 per cent, which is hardly the bonanza some have told us to expect.

If Italy is excluded from monetary union, rates may be lower but this may prove difficult, so an 11 member EMU may be politically more acceptable but at a cost of higher interest rates.

German public opinion still appears to be against the whole idea of giving up the deutschmark in return for an unproven alternative and the thought of inflation-prone Italy being part of the deal is anathema to Teutonic sensibilities.

Yet Germany itself may still fail to meet the entry requirements laid down in the Maastricht Treaty, so reducing its political clout in arguing for a narrower group of euro countries.

Consequently, the betting is firmly on a broad EMU but the corollary of this is that the fall in Irish rates will be lower than originally hoped. Paradoxically enough, the Government may not be too displeased with only a minimal fall in mortgage rates, as booming house prices have become a political issue and substantial falls in mortgage rates would add fuel to the fire.

Dr Dan McLaughlin is chief economist at Riada Stockbrokers Limited