Ireland faces 'double-edged sword'

Fri, Sep 2, 2011, 01:00

Weaker economic outlook, falling inflation rates and uncertainty over the European debt crisis could lead to a fall in the European Central Bank's interest rates by as early as next year, analysts said today.

But Goodbody chief economist Dermot O'Leary warned any reversal of the rate hikes would be a double-edged sword for hard-pressed Irish consumers.

The ECB will meet next week to decide on interest rates. There have been two hikes already this year, taking rates to 1.5 per cent, and analysts had previously expected interest rates to keep rising as the ECB tried to rein inflation closer to its 2 per cent target.

But on Monday, ECB president Jean-Claude Trichet said the bank was reviewing its assessment of inflation risks on slower growth in the euro area.

Goodbody said it was changing its forecasts to a prediction that rates would roll back to the previous record low.

"We now see the ECB cutting interest rates by 0.5 per cent, back to 1 per cent, in 2012, with the first reduction coming as early as the first quarter," Mr O'Leary said. "We previously suspected that further interest rate increases up to 2.25 per cent by the end of 2012 were likely."

The forecast is partly based on falling euro zone and global growth, backed up by recent economic indicators.

"The euro zone economy’s strong rebound was built mainly around the industrial recovery in the core, " Mr O'Leary said. "Recent indicators, such as yesterday’s manufacturing PMI, suggest that this recovery has faltered."

Members of the so-called shadow ECB council, a group of 15 economists and portfolio managers who watch economic developments and monetary policy in the euro region and issue recommendations each month, have called for a reversal of the rates to to prevent the euro-area economy from slipping back into recession.

A contraction in European manufacturing and plunging business and consumer confidence suggest the sharp slowdown in economic growth in the second quarter may continue in the third, they said.

"My recommendation is for the ECB to lower the policy rate by 50 basis points as insurance to lower the risk of outright recession re-emerging," said Julian Callow, chief European economist at Barclays Capital in London. "The economic deterioration has become sufficiently rapid and alarming to warrant an immediate unwinding of the ECB's rate hikes."

Inflation rates have also moderated in recent months, with headline inflation falling from 2.8 per cent in April to 2.5 per cent in August. Core inflation has fallen from 1.8 per cent in June to 1.2 per cent in August.

"The chance of further interest rate hikes has evaporated and a reversal of earlier increases now seems more likely," said Jennifer McKeown, senior European economist at Capital Economics, which isn't represented on the shadow council. "We have penciled in 25 basis point interest rate cuts in December and March."

However, Goodbody warned that the forecast was not all good news for Ireland. Lower interest costs for businesses and households will depend on the domestic banking system passing these on to borrowers.But with Ireland so dependent on exports to grow, a downturn in the euro zone and global economies may also impact growth here.

"On the negative side, lower economic growth internationally will have negative implications for exports," said Mr O'Leary.

Goodbody said it was leaving its macro forecasts unchanged.

Yesterday, NCB Stockbrokers cut its full-year economic forecast, expecting gross domestic product to contract by 0.7 per cent this year. Chief economist Brian Devine previously said he expected GDP to fall 0.4 per cent for the year.

Ireland's debt to GDP ratio is expected to be 9.8 per cent this year, compared to 10 per cent previously.

Additional reporting: Bloomberg