OECD report favours interest rate cuts to counter deflation

Interest rates can be cut further across the euro zone, according to the latest report from the Organisation for Economic Co-operation and Development (OECD).

In a new report on economic and monetary union, the OECD said slowing growth and subdued inflation suggest that the European Central Bank (ECB) could cut interest rates further. This view was backed by the new head of the European Commission, Mr Romano Prodi, the former Italian prime minister, who warned yesterday that the EU should take action against the possibility of deflation in Europe. This would mean cutting interest rates further.

The one-time economics professor also came out in favour of stronger controls on international capital markets.

Most analysts are currently divided over whether the ECB needs to cut rates from their current 3 per cent, but some are still expecting a cut to be announced as early as next month.

In the OECD report, EMU Facts, Challenges and Policies, the organisation also said it now expected growth in 1999 across the 11 euro zone countries to slow to 2 per cent from the 2.5 per cent it forecast late last year, a figure significantly down on the 2.9 per cent in 1998. But it also warns that the risks attached to the outlook are "unusually large". And if conditions in Japan do not improve, and economic contagion continues to spread, recovery in the euro zone would be stalled.

The OECD is also expecting a slowdown this year in both the UK and the US, the euro's two largest trading partners. This would further hit business confidence, which has already been damaged by turmoil in international financial markets, according to the OECD.

With growth slowing, inflation will hardly rise and this "may provide some further scope to ease the monetary policy interest rate below the current level of 3 per cent", the OECD said.

The organisation also warned that wage flexibility is more crucial than ever, with the possibility of nominal exchange rate depreciation forever blocked off, if firms are not to lose competitiveness in the event of excess supply and demand across regions.

"The capacity of wages to adjust rapidly to a change in labour market conditions is critical," the OECD economists said. They also cited Ireland and Holland as success stories in this area, showing that "significant gains can be reaped".

Other problems that could lie ahead for the euro zone countries lie in regional variations in growth and employment. "Wide and persistent differences in unemployment rates across regions of the euro area could place stress on the future operation of a single monetary policy," the OECD said.

And if regional prices do not adjust via wage flexibility more rapidly than in the past, growth will become more volatile.

"As one would expect with a common monetary policy, inflation differences should be smaller, but output fluctuations could rise. If this were to occur, it could pose a major challenge to policymakers," the OECD said.

It also warned that the composition of the governing council of the ECB, which includes the national central bank governors of the 11 euro zone members, could result in undue weight being placed on regional conditions.

Citing evidence that local conditions influence the way regional US Federal Reserve bank presidents vote on the Federal Open Market Committee, the OECD said the design of the ECB "is even more vulnerable in this regard. . .This, in turn, could make for inefficient choices in ECB policies".

The OECD also called for at least some co-ordination in corporate tax systems. The 29-nation think-tank also joined the US in its criticism of the idea of target zones to rein in fluctuations of the world's main currencies. It said that implementing target zones would face a number of problems. Moreover, there was no guarantee that such action would prevent wide swings in the euro's value.