ESRI warns that ECB will seek to raise rates

The European Central Bank (ECB) will seek to raise euro-zone interest rates at some stage next year, the Economic and Social Research Institute (ESRI) has predicted.

ESRI economist Mr Danny McCoy said yesterday that he believes the ECB will raise its key rate as high as 3.25 per cent before the end of 2003 as fears of deflation grow in the euro-zone.

Deflation, which occurs where overall prices decline, can lead to considerable problems for an economy, including higher unemployment and delayed spending. Many commentators believe that Germany could be on the brink of such a situation.

"If monetary authorities take deflation seriously, they will try to give themselves some space to cut rates," said Mr McCoy.

He believes that euro-zone rates are at such a low level that they would need to be raised before the ECB would have space in which to reduce them in a deflationary environment.

Euro-zone rates were reduced by 50 percentage points to 2.75 per cent last month.

"The half-point cut will be successful and then they will bring interest rates back up to a comfortable zone," said Mr McCoy.

He acknowledged however that a protracted war in the Middle East or elsewhere could upset this forecast.

The ESRI is also expecting the ECB to raise its targeted ceiling for euro-zone inflation, which currently stands at 2 per cent and has consistently been broken over past months.

Mr McCoy suggested that the ECB may now be more comfortable with an upper limit of between 2.5 and 3 per cent.

The ESRI expects GDP growth in the euro zone to rise from 1 per cent this year to 1.8 per cent in 2003.

Its latest predictions are based on the euro rising to $1.05 and 70p sterling a year from now.

Mr McCoy cautiously welcomed the European Commission's recent proposals on a more flexible interpretation of the Stability and Growth Pact, which governs Economic and Monetary Union.

Describing the Republic's Budget for 2003 as "pro-cyclical", particularly on capital spending, he called for the funding of capital investment to be detached from the pressures of cyclical movements.

The Commission's proposals may be "opportune" in this regard, Mr McCoy said. He warned however that "fiscal rules are never a panacea for deteriorating public finances".

The institute is forecasting that the Republic's general Government deficit will equate to 0.4 per cent of GDP this year and 0.7 per cent in 2003.

While still well within the 3 per cent limit set by the Stability and Growth Pact, the ESRI is concerned that this is close to the "safety margin" of 1.2 per cent set by the European Commission for the Republic. This would mean that the economy could breach the pact in a harsh downturn.