Sharp rate rise not in economy's interests

Economics: Some predict that, like an evil Santa Claus, the European Central Bank (ECB) will raise interest rates before Christmas and that there are many arguments as to why they might do so.

The first cited reason for rate rises is the nascent improvement in the euro-zone economy. Germany's economy - almost one-third of the euro zone's economy - is beginning to grow, and this implies that it will carry euro-zone growth and inflation up with it. Germany's growth is driven by exports, fuelled in turn by China's insatiable appetite for capital goods. That growth will help push up euro-zone growth, but not euro-zone inflation.

In what is the reverse of Ireland's position, Germany's strong export growth masks a very weak domestic economy. Consumer confidence in Germany is further subdued by the new government's plans to raise VAT and cut benefits.

This jobless growth, incidentally, mirrors the position that Ireland was in during the early 1990s, before a reduction in our tax burden stimulated our domestic economy.

And even when domestic demand picks up, there is plenty of slack in the German economy for domestically driven inflation to be avoided.

If inflation comes, it will come from the knock-on effects of oil prices. Interest rate rises are a blunt instrument to deal with this form of inflationary pressure.

The second argument for a rate rise relates to ample growth in the money supply. This has happened because the EMU brought average rates to historic lows. It is also because the end of the equity boom has driven funds into bond markets and driven down long-term yields, creating ample liquidity.

Another factor relates to once-off reductions in rates that occurred during 2001. The ECB responded to the events of 9/11 with a structural rather than a cyclical fall in rates in 2001. This came after a surprise rate cut in May of that year that was not justified by cyclical conditions.

The later 2001 cut was done in collaboration with the US Federal Reserve. The Fed has since corrected for this non-cyclical cut, but the ECB has not. The correct policy response to this second argument for rate increases would not be to start pushing up euro-zone rates in December.

Rather it would be to wait until cyclical factors - such as rising domestic demand or second-round effects - justify counteracting tightening. At that time, it could slip in additional rate increases to correct for historical generosity.

So, although today's ample money supply should affect monetary policy, it will do so by dictating the extent, but not the timing, of rate rises over the coming tightening cycle.

A third reason for tightening is related to the first; the existence of an asset bubble in more dynamic euro-zone economies, including Ireland. Last week, it was revealed that the OECD thinks our property market is overvalued by about 15 per cent. The Central Bank has not disagreed with this. It hopes that slower than expected growth in house prices will correct any froth over a few years. Another cure for this would be increased interest rates, as have occurred in Britain.

A final case for tightening is the upward impetus given to future euro-zone inflation by a strong dollar. Although the long-term omens for the dollar are negative, it is rising against the euro in the short term, as the Fed tightens and the ECB holds fast.

This accentuates the impact of the summer's oil price increases, whose effects are continuing their slow progress through the guts of the economy. As a result of this, inflation has risen in the euro zone, but so far the so-called "second-round effects" - when wage growth demands rise in response to rising inflation - are muted.

What would be in Ireland's interests? If it is to remain a credible institution, the ECB will have to raise rates some time over the coming three years. There are two ways that this can happen. The first is a gentle stroll up some stairs. The second is a quick dash up a ladder.

Men with heart conditions have been known to die from less. A series of modest rises separated from each other by several months would be infinitely better than a repeat of the previous tightening phase, when rates rose by 2¼ per cent between April 1999 and October 2000 - a period of just 18 months.

Since then, as the Central Bank notes, the ratio of personal debt to personal disposable income has doubled from about 60 per cent to about 120 per cent. As far as Ireland is concerned, a climb up the stairs is much more preferable to the dash up a ladder that was the case five years ago. The earlier rates start to rise, the more likely that we are in for a climb and not a dash. Those who fear the onset of rate rises should reflect on that.

What is likely to happen? Growth is returning to Germany, but it is largely jobless, export driven and non-inflationary. Money growth remains strong, but this justifies a structural correction of monetary tightening rather than a cyclical commencement. Buoyant asset prices also justify a correction in the middle of the tightening rather than the immediate start of tightening now.

Only oil prices and currency factors justify a rate rise and this justification is tentative. Furthermore, the ECB, while independent, does not exist in a vacuum. Although Jean Claude Trichet has said the ECB could raise rates at "any time", this doesn't mean that he will do so in December. Even central bankers believe in Father Christmas.