Euro may hit $1.40 before end of year

SUDDENLY the rediscovery of inflation in the United States by the Federal Reserve, their central bank, has sent currency markets into a tizzy.

Without much warning, the interest rate outlook has hardened not just in the US but in the European Central Bank also.

Earlier this week, the Economic and Social Research Institute was forecasting a 0.25% hike in rates by the ECB this year.

It was a pretty benign scenario, with the ESRI suggesting the most borrowers faced in more expensive borrowing was a hike of 0.75% over the next two years. Underpinning the hardening of attitudes are concerns about inflation in both economic zones.

On Wednesday, inflation figures in the US came in higher than expected, leading the Federal Reserve to suddenly get jumpy about rising prices. That shift in sentiment was deemed inevitable since oil prices have stayed so stubbornly high for the past 12 months.

The US administration has finally accepted that oil prices will not slip back to $40 a barrel any time soon and consequently, believes the new price structure will impact on prices in the US in the months ahead. Therefore, higher interest rates will be the classic response of the US Federal Reserve to dampen demand and keep prices in check.

We are not looking at US interest rates rising to 4% before the year is out.

Some say that is the minimum target for the year at this point as the US struggles with dearer oil and an economy that is sustaining trend growth of 3.5% this year and 3.1% in 2006.

How the dearer rates will impact on medium-term growth in the US is a matter of conjecture. One sure thing is if oil goes back to real record highs, then the situation could change dramatically. As things stand the dollar is suddenly making modest gains against the euro, with some forecasting a $1.245 to the euro exchange rate before long.

Others warn the deficits in the US are a real drag factor as far as global investors are concerned and that the euro could still hit $1.40 before this year is over. Oil prices at $55 a barrel, while a nuisance, do not look to be a real threat to global stability.

US Treasury boss John Snow said as much on Wednesday when inflation reared its ugly head and got central bankers in the US exercised. While dearer oil has become a fact of life it would not cause the growth in the US to unravel.

Most economists probably agree with that sentiment, but oil will remain an issue for the global economy. That looks to be beyond doubt as supply and demand are struggling to stay in balance with each other.

Dollar weakness is a separate issue and is linked to the fact that Americans are living beyond their means. The big imponderable for many investors is how long this live now philosophy can be sustained. In simple terms, it requires foreign investors to pump over $2bn a day into US bonds and stocks to allow the US to live beyond its means.

The popular economic perception is that the biggest economy in the globe can do this high-wire act with impunity.

In the middle of all this, the Irish economy is till continuing to defy gravity and all the indicators are that we are probably better geared to withstand any future shocks the global market can throw at us than we ever were in the past.

However, the shape of the global economy suggests we need to proceed with a certain amount of caution.