Inflation eased by strong euro

LAST week, we saw the European Central Bank yet again leave interest rates unchanged, with the core ECB rate remaining at 3.25%.

In recent weeks in this column, the conundrum facing central bankers in the US and Britain has regularly been the theme. That the ECB faces similar complexity in dealing with interest rate policy for its economic area is no less the case than in Britain or America. The message from the ECB president accompanying the decision to leave rates unchanged was a mixed one. The balance of risks determined that interest rates remain unchanged, with the recent strengthening of the euro being a central force in the decision. Other matters such as inflation, and associated pressures, together with consumer and business sentiment had much to do with the prevarication evident in the ECB’s medium term view about interest rates. ECB president Wim Duisenberg said that they aren’t putting up interest rates this time, but don’t rule it out in the future.

On balance, it is a reasonable message, as the ECB is dealing with a mixture of sometimes-conflicting forces in setting interest rate policy, just as its peers are in London, New York and elsewhere.

For instance, the flip side of the weakening dollar that Alan Greenspan and his colleagues in the US Federal Reserve are dealing with is the strengthening of the euro. On a trade-weighted basis the euro increased in strength by over 5% in the last quarter. This suggests that the recovery of the euro is a fully-fledged phenomenon. The effect of this is that the stronger euro will serve to lessen inflationary pressures in Europe as the cost of imports declines. In particular, the cost of oil, a dollar-priced commodity, is falling both in real and in exchange rate adjusted terms, and so this exerts an anti-inflation force across the eurozone economy.

However, the stronger euro does have a negative influence on the competitiveness of euro area exporters - although it has to be said that euro area exporters have been enjoying an environment of super-competitiveness in recent years because of the previous weakness of the euro. Nonetheless, that the exporters are hit by a strengthening euro has been reflected in recent business confidence surveys in Europe, which have seen a turnaround in favour of the negative in recent months.

As is the case elsewhere, equities have been weak in recent months in Europe, and this holds real economy risks also. It is now accepted that a weakening in asset value can have a negative-sentiment effect on consumers. However, equities are regarded as a lesser arbiter of consumer activity when compared, for instance, to house prices.

Weak equity markets always have the potential to favour holding off on corporate investment and this, combined with the strong euro impact on exporters is a real challenge. It can thus be seen that the ECB president wasn’t scare-mongering or being deliberately vague in saying no interest rate increase for now but maybe later. Interestingly, the Norwegian central bank raised interest rates by 0.5% because of the inflationary impact of what it regarded as excessive pay rises.

David Merriman, Bank of Ireland, Douglas, Cork.