Uncertainty over interest rates forces value of euro lower

Uncertainty over the future of European interest rates drove down the value of the euro yesterday morning after overnight gains, but the currency recovered later in the day amid fresh signs that the United States economy is slowing down. Evidence of rising inflation in the euro zone persuaded many analysts this week that the European Central Bank (ECB) will raise interest rates as early as August 31st, perhaps by as much as half a percentage point.

But amid speculation that the ECB's governing council, which is currently on holiday, might wait until September 14th to move on rates, the euro fell back from overnight peaks against the dollar and the yen. The trend was reinforced by rumours that a major US investment bank was selling large quantities of euros for dollars and yen. The euro fell to 90.64 cents from a high point of 91.77 cents. It was not until trading started in New York yesterday afternoon that the tide turned for the euro, as analysts interpreted a rise in consumer prices of just 0.2 per cent as evidence that the US economy is slowing down. This reinforced the expectation that the Federal Reserve will leave US interest rates on hold when it meets next Tuesday.

The ECB has made no secret of its intention to increase rates further from their present level of 4.25 per cent. Its current Monthly Bulletin stresses that all the risks to price stability are on the upside. The ECB believes that economic growth in the euro zone is strong enough and liquidity is generous enough to justify higher interest rates, but experience shows that rate hikes have only a short-term effect on the main blot on the ECB's record - the euro's low exchange rate.

A second factor in the euro's recent recovery may have been Germany's auction of mobile phone licences, in which bids reached €46 billion yesterday. Speculation that bidders from outside the euro zone might raise capital in other currencies before exchanging it into euros boosted the European currency.

Some analysts are sceptical about the impact the auction will have in real terms, partly because many of the bidders are cash-rich and have subsidiaries within the euro zone. But the auction will have an immediate effect on the German government, which plans to reduce the number of bonds it issues.

The unexpectedly high level of bidding has sparked a debate in Germany over how the windfall should be spent. The Finance Minister, Mr Hans Eichel, has promised to use all the money to reduce the federal debt, but he says that the interest saved - estimated at about three billion deutschmarks a year - will be used to finance specific projects.

The extra cash will blunt the effect of Mr Eichel's harsh public spending cuts and, along with his ambitious tax reform, should boost domestic demand. As the centre-left government moves into the second half of its four-year term later this year, the mobile phone windfall will put it in a stronger position with voters in the run-up to the next federal election in 2002.