Interest rates could rise over the coming months as the European Central Bank (ECB) embraces a tighter monetary policy, its president, Mr Wim Duisenberg, has indicated. Speaking in Frankfurt after a meeting of the ECB's governing council left interest rates unchanged at 2.5 per cent, Mr Duisenberg said a bias towards tightening monetary policy was "gradually creeping into" the bank's thinking.
"We do not see price stability being threatened at present but if money and credit growth increase further, a reassessment may be appropriate," he said.
According to Dr Dan McLaughlin, chief economist at ABN-Amro, the purpose of the comments may have been to boost the currency rather than hint at interest rate rises.
He added that the market would be extremely surprised at such a comment from Mr Duisenberg, particularly given the context of weak economic data out of Germany and extraordinarily low inflation numbers.
"The comment came out of the left field and has thrown the market into a lot of doubt about the direction of rates," he said.
As a result, euro interest rate contracts two years ahead are now trading on the market at 3.25 per cent, compared with a current official level of 2.5 per cent. This indicates an expectation in the market that base euro interest rates will rise over the period. The remarks also temporarily boosted the euro on the financial markets but it fell back again, closing at $1.0222 from $1.0216. It was trading around $1.02 in New York last night.
The currency has lost 15 per cent of its value since it was introduced in January and one of the German government's top economic advisers, Dr Horst Siebel, predicted this week that one euro could soon be worth as little as 90 US cents.
Mr Duisenberg officially brushed aside fears about the currency's falling value and repeated his conviction that the euro would recover sooner rather than later.
"The euro is firmly based on internal price stability and therefore has the clear potential to achieve a stronger external value," he said.
The ECB warned this week that the euro was being undermined by irresponsible economic policies in three of the core members of the euro zone. In a confidential report to EU finance ministers, which was leaked to the London Times, the ECB warned that Italy, France and Germany were dangerously close to breaching the Stability Pact.
Italy said last month that it was loosening its budget deficit target from 2 per cent to 2.4 per cent but the ECB report complains that France and Germany - which together account for half the total output of the euro area - are also in danger of overspending.
It says that a recent improvement in budget deficits was entirely a result of the fall in the cost of borrowing, which reduced the debt payments made by governments.
Mr Duisenberg was broadly optimistic about Europe's economic prospects, predicting a recovery throughout the euro area later this year. "While the signs of recovery are still modest and are not yet reflected in labour market developments, recent data appear to confirm the outlook for a continued improvement in the course of the year," he said.
