Fall in inflation puts Spain in place for rate cut and EMU

The Bank of Spain is expected to cut interest rates by a quarter of a percentage point today after figures yesterday showed a sharp drop in inflation. The new inflation figures raise the chances of Spain meeting the Maastricht criteria and joining EMU while leaving Italy on the sidelines.

The Spanish consumer price index fell by 0.1 per cent during February, bringing the annual rate of inflation down to 2.5 per cent, compared to 2.9 per cent in the year to January.

Julian Jessop of Nikko Europe said: "The markets were excited by the inflation figures. We expect the Bank of Spain to cut rates as soon as possible."

Spain failed to meet the Maastricht inflation criterion in January on the basis of the EU harmonised inflation measure, the HCIP, which put Spanish inflation at 2.8 per cent, 0.1 of a percentage point lower than the national measure. The Maastricht Treaty says that inflation must not be more than 1.5 percentage points above that of the three best-performing countries, creating a ceiling in January of 2.7 per cent.

But the inflation drop in February greatly increases Spain's chances of passing the inflation test in 1997. David Walton of Goldman Sachs said that if the ceiling remained roughly unchanged, and if the EU harmonised measure followed the national CPI, then the probability of Spain meeting the inflation criterion had risen from 73 to 96 per cent.

Falling inflation means that Spain has a better chance of meeting the other Maastricht criteria too, because it gives the Bank of Spain more leeway to cut interest rates. Julian Jessop of Nikko Europe said: "I don't think interest rates are being set to control inflation. Spain is much more concerned about growth. Meeting the deficit and debt criteria are the problem."

Spain has lower borrowing, lower debt and higher growth than Italy, giving it a much better chance of meeting the Maastricht criteria this year. Goldman Sachs forecasts that Spain's deficit will be 3.4 per cent in 1997, compared with the Maastricht 3 per cent limit. Mr Jessop said: "The Germans are less worried about Spain than Italy. Spain is a smaller economy, and would bring a much lower debt into EMU."

The prospect of Spain leap-frogging into EMU while EC founder member Italy is left behind could cause diplomatic problems. However, Philip Chitty of ABN Amro maintains that the most likely scenario remains that both Italy and Spain are excluded in the first wave. "The Maastricht Treaty talks about sustainable low inflation. It isn't clear to me that either country has yet achieved this."

Average earnings in Spain were rising 5 per cent a year and there were serious inflationary pressures in Spain and Italy.