The problem for the ECB is its inflation target of 2 per cent, with the monthly figure likely to remain above it for the rest of the year, writes Dan McLaughlin

Six months ago financial markets were anticipating rising interest rates in 2002, reflecting the belief that the global economy was recovering at a respectable pace following the downturn in 2001. Indeed, the European Central Bank clearly moved to a more hawkish stance on rates in April and May, prompting speculation that the cost of borrowing in Ireland would rise over the summer months.

Similarly, in the US, the Federal Reserve stressed that interest rates were unusually low so the market priced in a steady stream of rate hikes over the coming 18 months.

All this has changed, however, and now the market is pushing the first rate increases out to the summer of 2003, and ascribing a high probability to the prospect of further rate cuts.

A number of factors lie behind the change in mood. The US economy, which grew at a 5 per cent annualised pace in the first quarter, slowed in the second to just 1 per cent growth, prompting many to question whether this was merely a temporary hiccup or the precursor to a period of weak or even negative growth - a "double dip recession".

Falling equity markets did not help, nor did the spectre of rising oil prices and the scandals surrounding US corporate governance.

The prospect of a US strike against Iraq also loomed larger on the horizon, as the war rhetoric grew louder in Washington, increasing uncertainty for investors.

Consumer confidence in the US fell steadily over the summer months, as did business confidence, with the result that the market began giving a high probability to a quarter point cut in rates at the Federal Reserve Open Markets Committee meeting in late September, especially following the August meeting, which highlighted the downside risks to the economic expansion.

In Europe, also, consumer and business confidence slipped and the economy data was generally on the soft side; the Ifo index of German business confidence, for example, has fallen for three consecutive months.

Consequently, the market expected a quarter point cut in European Central Bank rates by the year end, with the Bank of England also seen trimming the 4 per cent repo rate by Christmas.

Supporters of this view could point to official comments from the respective central banks: minutes from the Bank of England meeting in August showed that the merits of a rate cut were discussed and the ECB modified its view on the inflationary risks in the zone to that of balance.

Yet, the market is now having second thoughts. The US consumer is still spending freely, particularly on cars, and rising property prices have cushioned household wealth in the face of lower stock markets. Mortgage rates have also fallen sharply, and record numbers of US households are refinancing borrowings, so freeing up income.

In addition, employment in the US has started to rise again, and the unemployment rate has stabilised around 6 per cent (in August it fell to 5.7 per cent)

Consumer spending rose sharply in July, and GDP growth in the third quarter is likely to be very strong, at 4 per cent plus, as investment spending also appears to be picking up, after two negative years.

Equity markets too are well up from the July lows, and the dollar's recent rise suggests that global capital is beginning to flow again.

Of course, the risk of terrorist attack is still out there but on the Iraq situation the market is beginning to feel that the risks to oil prices may not be as great as first thought - a swift end to the campaign would see Iraqi oil production rising sharply, adding some 1.5 million barrels per day to global crude supply.This is no doubt curbing the speculators, as oil prices have not risen as much as some expected in the past few weeks.

On that basis, a Fed cut is unlikely unless employment, which is rising modestly, slumps again.

Closer to home the problem for the ECB is that it is stuck with a headline inflation target of 2 per cent, with the monthly figure likely to remain above it for the rest of the year. Service inflation is the problem, reflecting a pick-up in wage growth and, if one excludes Germany, price rises in the service sector are running at around 3.5 per cent across the euro area, which implies that a good number of the European central banks would be against an easing of monetary policy.

The euro, too, may fall further, so reversing the summer rally which convinced the ECB that inflation would fall in 2003.

In Britain, the recent data have generally been much firmer, reinforcing the view that the World Cup finals and Jubilee celebration holidays distorted the June figures downward and so gave a misleadingly weak picture of overall activity.

All in all, the market may have got ahead of itself; there is a possibility of lower global interest rates, but I would not bank on it.

Dr Dan McLaughlin is chief economist with Bank of Ireland