It looks probable that the interest rate with which the European central bank will govern lending rates - as its monetary policies replace those of individual central banks as the guardian of price stability - will be higher than German rates, Europe's current benchmark, rather than lower or in line.
That could saddle some countries with higher rates than they need, crimping growth, while others may be at risk of higher inflation if official rates are too low to curb rising prices.
"For countries such as Spain, we're likely to see an interest rate setting which is too low, while for Germany and France it'll be quite the opposite," said Darren Williams, European economist at UBS. "A rate of 4.5 per cent for the European central bank seems likely."
The official German interest rate is 3 per cent, compared with 5.25 per cent in Spain and 6.25 per cent in Italy. Those gaps are wider than you'd expect of countries less than 16 months away from merging control of their economies, so something has to give.
If the euro is introduced as planned, those adopting it will have the same official interest rate. That will push money market rates together, since it would be illogical for companies to be able to borrow euros at a lower rate in Germany than they pay in Italy. While bond yields have converged rapidly in recent months, the gap between money market rates has proved less susceptible to convergence.
As a guide to where the key European interest rate may settle after 1999, the one-month rate for the European currency unit, which comprises a basket of European currencies and is the EU's forerunner to the euro, is about 4.28 per cent.
Makes you wonder what the prospects are for Italian inflation, given the Italian central bank sees a need for interest rates of more than 6 per cent, or the outlook for German growth, with the Bundesbank keeping its rates at record lows of 3 per cent for more than a year in an effort to kickstart the economy.
"For the convergence process, I see 75 per cent of it as a result of falling Italian rates, and 25 per cent as a result of a slight increase in German interest rates," said Fabio Mazzilli, bond manager at Ducato Gestioni in Milan.
Forward curve analysis, which determines where interest rates are expected to be in the future based on where rates for different maturities are now, shows expectations for European rates at the start of 1999 have changed dramatically in the past six months.
Two-year German yields, now about 4 per cent, are expected to rise to about 5.08 per cent. Italian yields are expected to drop to 5.5 per cent from about 5.8 per cent. That would narrow the gap between the two markets to about 50 basis points from 180. Three months ago, the same analysis showed German two-year yields of 4.7 per cent in 1999, compared with Italian rates of 6.3 per cent - a gap of 160.
There's been a similar shift in Spanish forward yields, which were expected to rise away from German levels, and are now narrowing the gap.
Driving that change: Bundesbank warnings it will act fast if it gets a whiff of inflation, even though its chief, Hans Tietmeyer, warned last week that "room for manoeuvre will be smaller" on changing rates as the deadline for the euro's introduction nears.
"Rate convergence will continue, but remember, German rates may go up as well as Italian rates falling," said Tim Stevenson, a money manager at Henderson Investors.
The Bundesbank's record on keeping inflation low has enabled it to keep its interest rates lower than countries which haven't been as successful in keeping prices under control. Germany's average annual inflation rate of 1.6 per cent in the past two years, for example, compares with 3.7 per cent in Italy and 3.3 per cent in Spain.
Once a single currency is in place, however, the European central bank will set rates based on what it deems appropriate to maintain price stability across Europe. "I don't think people fully appreciate that the European central bank won't be setting interest rates on the basis of German domestic consumption," Darren Williams said. "It's right to look at the Bundesbank now, though six months down the line, we might have to widen our perspective."
With European finance ministers agreeing last weekend that the group of countries deemed fit to join the common currency will be decided in May, money market rates across Europe are likely to move closer together in the coming months, with gaps likely to disappear several months before the scheduled start date for the euro.
"The market is discounting interest-rate convergence," said Chema Caballero, a fixed-income fund manager at BSN Gestion in Madrid. "German interest rates are too low; it seems reasonable to think they should have more of a risk premium because of the single currency."
Additional reporting: M Jacobs, Jeffrey T Lewis, Philip Sanders. Last week's column was reported entirely by Kerrin Howard.
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