Interest rate disparity causes euro to fall

Economics: Official interest rates in Britain stand at 4 per cent, having risen by half a percentage point since November, and the Bank of England (BoE) looks set to increase borrowing costs again, taking the repo rate there to 4.25 per cent over the next month or so.

In contrast, the European Central Bank (ECB) is sending very different signals, and the market is no longer expecting an interest rate rise this year in the euro zone. Indeed, sentiment has swung completely, with many prepared to bet that the next move in euro interest rates will be down.

The Bank of England is confident that the global economic recovery is well established and that it will help propel the British economy to very healthy growth rates. Gross domestic product (GDP) is forecast by the BoE to rise by 3.5 per cent in 2004, followed by 3.1 per cent in 2005. This is well above the economy's potential rate of expansion (generally put around 2.5 per cent). The implication is that growth of this magnitude will put further pressure on an already tight labour market and lead to upward momentum in prices, taking the inflation rate up to the 2 per cent target over the two-year forecast horizon. Moreover, the BoE had expected UK consumer spending and house price inflation to slow, but this has not materialised, so increasing the chances that economic growth will actually exceed the bank's forecast, and thereby increasing the risk of an overshoot in inflation.

The housing market is an added cause of concern for some policy makers in Britain, with the strength of mortgage borrowing and the size of household debt an additional argument for higher interest rates.

The ECB is also reasonably confident about the global recovery, but is showing signs of concern about the sluggish nature of euro-zone growth.

The economy grew by only 0.6 per cent in the year to the fourth quarter of 2003, which not only compares very unfavourably with Britain (2.8 per cent growth over the same period) but is well below the zone's potential growth rate of around 2.25 per cent.

The last thing the euro-zone economy needs, one might think, is an appreciating currency, but that's what it got through 2003. The markets seized on this and expectations grew from December onwards that the euro's strength would, at worst, postpone any monetary tightening by the ECB or, at best, lead to a rate reduction.

This argument has lost credibility, partly because the ECB revised up its export forecasts after a more upbeat assessment of global growth, and partly because the euro lost momentum on the foreign exchanges in January, and has since fallen by 3 per cent in trade-weighted terms.

The ECB has shifted the debate to growth, nevertheless, albeit away from the external sector and on to domestic demand, particularly consumer confidence and spending. The latter has been extremely sluggish, growing by just 0.3 per cent in the euro area over the past nine months of 2003, with consumer spending in Germany actually falling by 1 per cent over the period.

Consumer confidence in the euro area has risen steadily since hitting a 10-year low in the spring of 2003, but is still shy of its long average and substantially below the levels recorded in the late 1990s.

The optimum policy response might be to ease fiscal policy, as in the US, but this is not possible under the Growth and Stability Pact, thereby throwing all the weight on to interest rates and the currency.

The ECB has to decide whether consumer spending will eventually respond to the brighter global economic backdrop or whether it should cut interest rates in an effort to kick-start the process.

The latest data on consumer spending for France and Italy in the past week have been much stronger than expected, which, with other releases on external trade, points to an acceleration in euro-zone GDP growth in the first quarter, although the impact of the Madrid terror attack on Spanish data remains to be seen.

Other points for the ECB to ponder are whether lowering the cost of borrowing, particularly by a marginal amount, will do much to change things in Germany, where structural problems seem to be of more importance, and the desirability of adding further fuel to booming housing markets in some countries, including the Republic and Spain.

Even if the ECB does nothing, the implication remains that UK interest rates may soon be at least 2.25 per cent above those in the euro area, which partly explains why the euro has fallen by 8 per cent against sterling over the past year.

Dr Dan McLaughlin is chief economist at Bank of Ireland