Conditions good for rate cuts

Davos in Switzerland has just played host to the World Economic Forum, where the captains of industry and politics meet to discuss and review global economic prospects.

The meeting, which concluded early this week, occurred at a crucial time for a global economy that is in the process of shifting to a slower pace of cyclical economic growth.

The tenor of the comments from business leaders was that economic growth in the US is slowing down faster than statements from politicians and central bankers would have us believe.

For example, George Soros stated that he believed US growth was slowing down rapidly and that the Federal Open Markets Committee (FOMC) was likely to overshoot in lowering interest rates.

Mr John Chambers, chief executive of Cisco Systems, which builds communications infrastructure for companies and governments, warned investors that the US economy is slowing down much faster than most people realise.

Meanwhile, in a highly significant speech to the US Congress, the US Fed chairman, Alan Greenspan, recently highlighted the fact that the faster rate of productivity growth now being experienced by the US economy is likely to be sustained over the long term.

This has strong implications for both fiscal and monetary policy. The sustained improvement in productivity underpins forecasts of a large and growing budget surplus, leading Mr Greenspan to acknowledge that a policy of tax cuts is now appropriate for the US economy.

These comments must have been music to the ears of the new Bush administration. For monetary policy the implications of this faster rate of productivity growth is that the long-term non-inflationary growth rate of the US economy has shifted upwards.

This implies that there is now more room for interest rate reductions without stimulating inflation.

By the time you read this, it is likely that the Fed will have announced a further reduction in US interest rates, probably to 5.5 per cent.

As the year progresses, further reductions are likely in US interest rates - depending on the extent of the US economic slowdown.

For the rest of the world the likely evolution in interest-rate trends for the remainder of the year seems fairly clear.

In the Far East, the Japanese economy seems unable to extricate itself from recession. Japanese interest rates continue to hover close to zero and there is simply no room for any further easing in monetary policy.

Furthermore, there is a feeling that many other Far Eastern countries have failed to fully repair the damage done to their financial systems after the 1998 financial crisis.

Therefore, there is absolutely no prospect of higher yen interest rates, given the structural weakness of Japan and several others Far Eastern economies.

In contrast, euro and sterling interest rates are experiencing something of a two-way pull. Economic growth remains robust and indices of consumer and business confidence in both Europe and the UK are reasonably strong.

However, inflation is well behaved and both UK and European inflation seem set to remain around the long-term target level of 2 per cent to 2.5 per cent. These favourable inflation prospects should be sufficient to enable European central banks to follow US interest rates downwards.

However, the extent and pace of European declines will be quite different. Given that UK interest rates are still almost one point higher than euro rates, there does seem to be scope for some early reductions here.

In contrast, for the euro zone, an early decline seems unlikely, particularly in view of the fact that euro rates are still well below US and UK rates.

Therefore, although Irish business and consumers can expect to see lower interest rates sometime during 2001, any such reductions are likely to come later in the year.