Money supply growth dampens spirits

The news that Germany's biggest union has agreed a modest pay deal in the country's most populous state ought to warm the anti-inflationary hearts of Europe's central bankers as they gather in Madrid tomorrow for the fortnightly meeting of the Governing Council of the European Central Bank (ECB).

But yesterday's good news from North-Rhine Westphalia, where the engineering union, IG Metall, accepted a pay increase of around 3 per cent, was soon overshadowed by the announcement of strong growth in the money supply in the euro zone.

Few analysts expect the ECB to raise interest rates tomorrow, just two weeks after it pushed its main refinancing rate up 25 basis points to 3.5 per cent. But the latest money supply data have reinforced expectations that the cost of borrowing will increase again within the next two months.

Broad money supply, known as M3, rose by 6.2 per cent on an annual basis in February, compared with 5.2 per cent in January.

Mr Michael Schubert, an economist at Commerzbank in Frankfurt, believes that the ECB will not tolerate such money supply growth for long, given that the Bank's reference rate for M3 is set between 4 and 4.5 per cent.

"The unexpectedly strong growth is a negative surprise. We see that strong economic growth is having a bigger impact than we have so far recorded. This delivers the ECB a strong reason not to wait too long with another interest rate rise," he said.

The ECB considers two criteria when it sets interest rates - the consumer price index and the growth in money supply. Yesterday's pay deal in Germany, which follows a similarly modest settlement in the chemicals sector, will help to dampen inflation.

And a commitment by OPEC to increase oil production, thus reducing the price of oil from its present, unusually high level, would also help to keep inflation down. But the Bank is concerned that, as companies borrow more money, the second pillar in its monetary policy strategy is looking increasingly shakey.

The ECB is unlikely to allow M3 growth to remain above 6 per cent for much longer but Deutsche Bank economist Mr Stefan Bielmeier cautioned against a knee-jerk reaction to the latest figures.

"We don't expect any worrying acceleration going forward. We're in the rising part of the economic cycle and that's why money supply requirements are growing," he said.

Tomorrow's governing council meeting in Madrid will be the first to take place outside Frankfurt since the euro was launched last year and is likely to be the first of a succession of away-days aimed at bringing the ECB closer to the people of the euro zone.

Like Ireland, Spain enjoys a higher growth rate and higher inflation than most euro zone countries and its economy could benefit from higher interest rates.

The ECB president, Mr Wim Duisenberg, believes that the Bank has done a good job in tweaking interest rates at just the right time to avoid inflation while encouraging growth.

But the euro's weak exchange rate remains indifferent to the economic good news all around it and the currency continues to perform poorly against the dollar.

Mr Duisenberg insists that the euro will rise in the medium term but many analysts blame the currency's flaccid performance on a lack of confidence in the ECB and confusion over the Bank's intentions.

If Mr Duisenberg is to persuade the financial markets and the people of Europe to love the euro more, he may need to do more than change the venue for the Governing Council meeting - which will take place tomorrow, as always, behind closed doors and with no published minutes.