Euro slides despite ECB rate hike

NEWS ANALYSIS: Bank of England leaves UK rates unchanged but pressures mount to follow the Europeans
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The Independent Online

There should have been no surprise at the European Central Bank's decision yesterday to raise its key interest rate by a quarter-point to 4.75 per cent, according to Wim Duisenberg. The ECB president listed multiple reasons for the decision: the high price of oil, strong growth in the 11 member countries, the weak euro, above-target inflation and ample monetary growth. "The direction of the move can have come as no surprise to the markets," he said.

There should have been no surprise at the European Central Bank's decision yesterday to raise its key interest rate by a quarter-point to 4.75 per cent, according to Wim Duisenberg. The ECB president listed multiple reasons for the decision: the high price of oil, strong growth in the 11 member countries, the weak euro, above-target inflation and ample monetary growth. "The direction of the move can have come as no surprise to the markets," he said.

The timing was a surprise, however. The ECB decision came an hour after a "no change" vote from the Bank of England, meaning that UK interest rates have stayed flat at 6 per cent since February, the longest period of stability since the MPC was formed in 1997.

It was also two days after the US Federal Reserve Board's policy committee decided it could also afford to wait and see on interest rates. Eurozone interest rates have almost doubled in 12 months, in a far more aggressive tightening policy than in either the US or UK, although the ECB's interest rate level remains significantly lower.

Yesterday's increase was scant help to the weak currency. The euro dropped below $0.87 for the first time since the joint G7 intervention on 22 September, even though Mr Duisenberg said the threat of further intervention remained. As long as the euro remains so weak it will add to the inflationary pressures in Euroland through higher import costs - especially the cost of oil.

While the weak exchange rate is a specific problem for the ECB, some of the influences pointing to higher borrowing costs are common to all the leading economies. Even in Japan, just escaping the economic doldrums, rates have increased. Many analysts believe this week's decisions to hold interest rates in the US and UK have merely postponed the evil day, and predict further increases across the board in the months ahead.

This includes further moves from the ECB too. Mark Cliffe, chief economist at ING Barings, said: "The very fact that they've moved now is an indication of just how concerned they are about the potential upward pressures on inflation."

Others see a more urgent need for action in the US. The decision this week was widely anticipated. As Gerry Holtham, chief investment officer at Morley Fund Management, put it: "The Fed was never going to raise interest rates when the evidence about how much the US economy is slowing was so Delphic and the presidential election is looming."

However, a clear signal of future rate increases was given in the Fed's statement earlier on Tuesday. It said: "The increase in energy prices, though having limited effect on core measures of prices to date, poses a risk of raising inflation expectations."

Stephen Lewis, of Monument Derivatives, said this indicated the Fed was prepared for now to err on the side of sustaining growth rather than cracking down on inflation, but would correct its stance if there were signs of second-round inflationary effects from higher oil prices. "They will correct the mistake if higher inflation turns out not to be simply oil-related and temporary," he said.

The Monetary Policy Committee did not issue a statement yesterday, but minutes of the previous two meetings show that the absence of further effects from rising oil costs, particularly in wage claims, have been important in swaying the vote against increases.

Businesses and unions claim there are no inflationary pressures worth worrying about. Kate Barker, the chief economic adviser at the Confederation of British Industry, said yesterday: "Firms remain focused on cost control in the face of powerful global competition. This should offset inflationary pressure caused by falling unemployment."

John Monks, TUC general secretary, went further. "Once the oil price has stabilised, there is a growing case for the next move in interest rates to be down, not up. Inflation has now undershot the target for 18 months and looks likely to continue to do so," he said. But many City economists, not to mention the hawks on the MPC, are not so sure. Ian Stewart, UK economist at Merrill Lynch, said: "It's not that the UK has a big inflation problem but the MPC probably ought to have raised rates. They might have to increase them more later as a result."

Although the economy's pace of growth is expected to slow, the issue is whether it is slowing fast enough amid signs of rising prices in the service sector and even on the high street. Yesterday, the British Retail Consortium, having long complained about retailers' lack of pricing power, reported the first increase in its shop price index for 16 months.

In the UK, as elsewhere, the key underlying factor has been the surprising strength of the economy during the past year or so. World growth has been surprisingly strong, due to both the remarkable American growth performance and the strong recovery in developing countries after the 1997-98 Asian crisis. The pace of world demand helps explain the jump in oil prices. Working against the inflationary demand pressures has been the US supply side miracle, with improved productivity boosting the rate of growth the economy can sustain.

In its recent forecasts the International Monetary Fund predicted a soft landing for the world economy, with growth slowing gently but not too much next year and inflation remaining stable. But it added: "The amount of monetary tightening that may be needed to control inflationary pressures in the United States and some other countries remains unclear, especially if the increase in oil prices is sustained."

If the oil price stabilises or falls and the New Economy enthusiasts are right about the further potential for productivity gains, interest rates will not need to rise very much further. Nor, however, are they likely to start falling on either side of the Atlantic. "Are interest rates peaking soon? No way," said Catherine Lee from Royal Bank of Scotland.

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