Lower interest rates likely to counter deflation risk

Investor An insider's guide to the market On the surface, the outcome of last week's separate meetings of the world's three most important central banks proved to be an anti-climax for those expecting some change in official interest rates.

In the US the Federal Reserve left dollar short-term interest rates unchanged at 1.25 per cent and in Britain the Monetary Policy Committee left the sterling repo rate unchanged at 3.75 per cent.

The European Central Bank (ECB) also held its key short-term interest rate steady at 2.5 per cent despite some recent evidence of further weakness across the euro-zone economy. Although there was no apparent change in interest rate policies, a closer examination of the statements issued by the various central bankers points to some significant shifts in monetary policies.

In Europe, the ECB signalled that it was concerned about deflationary risks and that it would act to prevent inflation falling below 1 per cent. Therefore, its inflation target is to maintain inflation in a range of 1 to 2 per cent.

Mr Wim Duisenberg, the ECB president, argued that this was merely a presentational change and that it did not reflect any substantial change in monetary policy. But the ECB's statement is being viewed by many commentators as reflecting increasing concern about the risks posed by deflationary tendencies across the euro-zone economy.

Annual inflation in the euro zone is now running at 2.1 per cent and could soon fall below 2 per cent. The slackening rate of inflation and the ongoing slowdown in economic growth has led many economists and influential institutions to call for lower interest rates.

Many analysts believe that a reduction in euro-zone interest rates in the coming months of at least 0.5 per cent is fully justified by current economic conditions. They take the view that the ECB's monetary policy is now seriously "behind the curve" and are fearful that an inappropriately tight monetary policy could plunge Europe into an outright recession.

These fears have been heightened by the appreciation of the euro over recent months. The current euro-dollar foreign exchange rate of $1.16 means the euro is now almost back to its opening rate against the dollar. Most foreign exchange analysts expect the euro to hold onto its gains and indeed some forecasters are now predicting that the euro-dollar rate could go as high as $1.30 before the end of the year. This appreciation in the euro will exacerbate current trends of falling inflation and slowing economic growth across Europe.

The dramatic recent appreciation of the euro could well be the catalyst that forces the ECB to reduce interest rates.

Looked at from the Irish perspective, the magnitude of this recent exchange rate change becomes apparent when translated into the old pound-sterling exchange rate. The current euro-sterling rate of £0.717 translates into a notional pound-sterling rate of 91 pence sterling. Further strength in the euro could push this notional rate very close to parity.

Given the importance of the British market to Irish business, such a sharp appreciation in the currency over a short space of time is bound to damage Ireland's international competitiveness.

This is a particular danger given that Irish inflation is running at a rate that is substantially higher than either European or British inflation rates. The net impact of this sharp appreciation in the euro on the Irish economy will be to reduce economic growth and to reduce inflation.

Given the very high Irish inflation rate the appreciation in the exchange rate may well be appropriate as long as the impact on economic growth is modest.

However, for the European economy as a whole the strengthening euro seems to be wholly inappropriate. Economists estimate that the appreciation of the euro in recent months is equivalent to a rise in interest rates of 0.5 per cent. Therefore, just to maintain the prior monetary stance the ECB needs to lower short-term interest rates to 2 per cent or even lower.

The reluctance of the ECB to cut interest rates stands in sharp contrast to the approach adopted by the Federal Reserve in the US. The Fed has acted in a pre-emptive fashion to lower US rates to the current very low level of 1.25 per cent.

Although rates were not lowered at its most recent meeting, Federal reserve chairman Mr Alan Greenspan made it clear that the Fed stood ready to lower rates if warranted by economic conditions.

So a further cut in US interest rates is a possibility and the bias in the Fed is to keep monetary policy loose in order to foster economic growth.

Overall, the dangers posed to the world economy by deepening deflationary trends are greater than the risks of a return to an inflationary spiral. In such an environment interest rates are unlikely to rise from current low levels and further downward interest rate moves in the US and Europe continue to remain a strong possibility in coming months.