The risk of Europe-wide deflation, although real, is still relatively low, writes Dan McLaughlin

Irish interest rates are very low by historical standards: the recent half-point cut by the European Central Bank (ECB) took the repo rate down to 2.75 per cent - a far cry from the double-digit rates familiar to Irish borrowers from the 1960s onwards.

In fact, the repo rate was lower as recently as 1999, at 2.5 per cent, but rose within six months from that level, which begs the question whether the next move will be up, and soon, or whether rates could well fall further.

The US central bank, the Federal Reserve, recently trimmed interest rates there to only 1.25 per cent, and the cost of borrowing cash in Japan is virtually zero. So the notion of further rate reductions in Ireland is by no means fanciful.

Central bankers spent the second half of the 20th century fighting inflation, a rise in the general price level, but in the past few years a new spectre has emerged to haunt policy-makers - the threat of deflation, or a fall in the general price level.

For Irish readers, facing another year of inflation around 5 per cent, this may seem a remote possibility; but for the Fed and the ECB, the prospect of deflation has moved from being virtually inconceivable to a possibility, remote perhaps but certainly not impossible.

Japan provides the best modern example of persistent deflation: consumer prices there have been falling since 1998 and wholesale prices are currently 6 per cent below their level five years ago.

What's wrong with falling prices, one may ask? The answer is that it can have malign effects, which ultimately causes severe damage to an economy.

If prices are expected to fall, there is every incentive for consumers to defer purchases and to save cash, which will buy more tomorrow. So consumption suffers, leading to lower production and higher unemployment.

For borrowers too, the process is painful, as the real value of their debt increases, and it is not surprising then that bank lending in Japan has been falling steadily for over five years - why borrow cash today, even at zero interest rates, when cash tomorrow will be worth more?

Much time and effort has been devoted to studying deflation in Japan and the lesson is that prevention is better than cure - central banks should act aggressively to head off the threat of deflation because it is so difficult to dislodge once established. This means cutting rates aggressively, particularly at low levels, as the impact of marginal changes begins to diminish.

On this view the ECB still has plenty of room to manoeuvre, should it perceive the risks of deflation as increasing. Certainly the situation in Germany bears scrutiny: inflation there is running at 1 per cent, with goods inflation at only 0.5 per cent, having risen from zero earlier in the year.

Yet the risk of Europe-wide deflation, although real, is still relatively low. Globalisation, free trade and excess capacity in world manufacturing has put downward pressure on traded goods but the price of services is still rising, at over 3 per cent in the euro area as a whole, and at much higher rates in some of the peripheral member-states, including a 6.8 per cent reading in Ireland.

Most services are traded internationally so competition is not as intense, and productivity is low, so wages are the driving factor in service prices. Consequently, a sustained fall in the price level requires falling nominal wages, which seems a remote possibility given the relatively low rates of unemployment in many economies.

Furthermore, deflation is not consistent with healthy monetary growth which is the case in Europe and indeed the US.

So the next move in Irish interest rates could indeed be up, with the timing dependent on the pace of the global recovery. This lost momentum in 2002 thanks to fragile stock markets, higher oil prices and the uncertainty over military action in Iraq, but should gain traction in 2003, assuming that the Iraqi situation is resolved in the coming months.

If so, business spending will pick up across the globe, after falling for two years, and economic growth will accelerate. This will ultimately prompt a cyclical upturn in interest rates, perhaps by the autumn of 2003, as the ECB responds to the prospect of higher inflation in 2004.

The good news is that we won't get one without the other - rates will be on hold in the absence of recovery, and rise only if European and hence Irish growth accelerates to potential and above.

• Dr Dan McLaughlin is chief economist, Bank of Ireland