Wim grapples with exchange rate conundrum

The mood at Frankfurt's Eurotower should be more relaxed today when the governing council of the European Central Bank (ECB) meets for the first time since this month's surprise increase in interest rates.

The bank's president, Mr Wim Duisenberg, and his fellow central bankers have succeeded in changing expectations about the future course of interest rates, with most analysts now predicting the base rate will rise to at least 4 per cent by the end of 2000. Until this month, few were predicting the ECB would raise rates above 3.5 per cent by the end of the year. But this month's unexpected move has persuaded many on the money markets that rates could rise to 3.5 per cent as early as March 2nd.

One reason the markets expect rates to rise is that Europe's biggest economies have finally turned the corner and are heading for a surge in growth this year. A Reuters poll of economists on Tuesday found that most expect the euro zone's gross domestic product (GDP) to grow by 3.05 per cent this year, compared to just 2.2 per cent last year. Merrill Lynch last week raised its growth forecast for the euro zone in 2000 to 3.5 per cent and even the ever-cautious ECB is signalling that growth could exceed 3 per cent.

The driving force behind the recovery in Europe's biggest economies has been the weakness of the euro against the dollar, which makes European exports more competitive. But, as domestic demand picks up, the euro's low exchange rate against other currencies carries more risks than benefits - as the ECB acknowledged when it raised interest rates this month.

The weak euro - which has lost 15 per cent of its value against the dollar in the past year - could drive inflation up to 1.9 per cent in the euro zone this year, according to the European Commissioner on Economic and Monetary Affairs, Mr Pedro Solbes. This figure is dangerously close to the ECB's inflation limit of 2 per cent.

There is little sign, however, that increasing interest rates will be enough to lift the euro on foreign exchange markets and most economists predict it will remain around parity with the dollar throughout the year.

This weakness is bad for the currency's image and does nothing to enhance the authority of the ECB and its president. Mr Duisenberg has tended to blame everyone except himself for the currency's weakness. First it was Germany's former finance minister, Mr Oskar Lafontaine, whose radical economic proposals frightened the markets. More recently, Mr Duisenberg has lashed out at the German chancellor, Mr Gerhard Schroder, for intervening to save a troubled construction firm.

As for the markets themselves, the ECB president never tires of predicting that they will soon appreciate his own wise stewardship of the currency and buy euros accordingly.

Mr Duisenberg's latest target is the trade union movement and he claimed last week that the most recent interest rate rise was intended as a "warning" to unions not to make excessive wage claims. The leader of Germany's biggest union, IG Metall, this week told the ECB president, politely, to get lost.

Mr Duisenberg may now be regretting his intemperate criticism of the German chancellor, who is more popular than ever among voters and is presiding over an economic strategy that is winning praise from all sides.

Mr Schroder scored another success this week when France withdrew its opposition to Germany's candidate for the leadership of the International Monetary Fund (IMF), Mr Caio Koch-Weser. Although the US has yet to approve the nomination, Washington is unlikely to oppose a candidate backed by the EU.

German officials claim that France backed down when it became clear that failure to back Mr Koch-Weser could hand to an American a post traditionally held by Europe. But Paris is likely to expect a reciprocal gesture from Berlin when a French candidate needs support for an important, international financial post.

France has not forgotten an unwritten agreement that Mr Duisenberg will step down half way through his eight-year term as ECB president to make way for the present governor of the Banque de France, Mr Jean-Claude Trichet.

Mr Duisenberg has stated he has no intention of leaving early and his friends insist there is no mechanism to force him out of the job before the end of his term. But if Paris piles on the pressure in the run-up to 2002, the outspoken Dutchman can no longer count on the support of his erstwhile champions in Berlin.