Central banks set to bid adieu to cheap cash

Economics/Dan McLaughlin: For the past three years the global economy has been awash with cheap money - interest rates are zero in Japan, 1 per cent in the US and 2 per cent in the euro zone, a configuration not seen for more than 40 years.

Cheap money is not an end in itself, and was designed to soften the global downturn and to encourage eventual recovery. The evidence is accumulating that the policy has been a success - the global economy outside Europe is growing rapidly again - and so the vista facing us now is the end of cheap money, as it has served its purpose.

The UK has already begun the process but market attention is now focused on the US, given its pole position as the world's largest economy and the change in stance evident from the Federal Reserve.

The message emanating from Washington is clear: US interest rates are going to rise - and pretty soon at that. Where the Fed leads the European Central Bank (ECB) follows, so the next move in rates in the Republic is likely to be upward, contrary to market expectations only a month ago.

The prime catalyst for the change in US sentiment on interest rates is the performance of the economy over the past nine months.

The US has grown by 4 per cent over that period and there is little to discourage expectations of 4-5 per cent growth over the coming year. Consumers in the US are spending and businesses are beginning to invest, encouraged by buoyant profits, low interest rates and strong demand at home and abroad. Crucially, corporate America is also beginning to hire again, so employment, the missing piece of the recovery jigsaw, is finally falling into place.

Growth by itself would probably not be sufficient to trouble the Fed, but inflation has also begun to move higher, even allowing for rising oil prices. As yet, the upturn in inflation has been modest, but a succession of negative surprises on the annual inflation data has been enough to convince the US central bank that the risk of deflation has passed and that inflation has bottomed.

A change in the Fed's stance was formally acknowledged with a statement following its meeting on May 4th. Since January, it had stated that it could be "patient" in removing its "policy accommodation" (central bank speak for cheap money) but patience is now at an end, with the Fed stating that policy accommodation will be removed. It did add the rider that this removal would be at a pace "that's likely to be measured" but rates will still move higher, either in June or August.

The euro zone's growth performance has been a tortoise to the US hare, so the prospect of the ECB tightening policy soon is remote. Indeed the ECB appears to be split between two schools of thought. One, the Germanic school, tends to see impediments to growth as structural (rigid labour markets and the impact of German unification for example) and, as such, not amenable to marginal changes in short-term interest rates.

Moreover monetary growth in the euro area is already pretty strong, which risks higher inflation in the future, it is argued.

The alternative view argues that growth has been below trend for a long time, and that consumer confidence and spending would benefit from lower interest rates, particularly as inflation is not a threat.

A few months ago the latter view seemed to be in the ascendancy, but of late one senses that events have overtaken it - inflation has moved up to the 2 per cent target, oil prices have risen sharply and survey evidence points to a pick-up in the pace of recovery.

So the window of opportunity for the ECB to cut may well have passed, which means attention now switches to the likely timing of a move higher, particularly in the wake of the Fed's May statement. The good news for Irish borrowers is that the pace of growth in the euro area is such that the ECB may not have to act for some time - certainly not till the latter months of 2004 and some would argue for 2005.

But if money is cheap now, what constitutes fair value? In other words, at what level of interest rates would policy cease to be accommodative ?

In the US, the answer may be around 4-4.5 per cent, while in the euro zone, an ECB repo rate of 3.5-4 per cent could be said to be the minimum. That's not to say that rates can't move higher than this over the cycle but these are plausible targets for the respective central banks to aim at once they begin the tightening cycle.

Dr Dan McLaughlin is chief economist at Bank of Ireland