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Interest rates on the bounce

The European financial markets had consequently reacted even before the actual increase. Prices of bonds had dropped, share indexes wilted and the euro hardened, writes DH Pai Panandiker.

india Updated: Jun 15, 2007 22:14 IST

On June 6, the European Central Bank raised the rate of interest, as expected, to 4 per cent. The ECB President Jean-Claud Trichet had earlier called for ‘strong vigilance’ in respect of inflation, a phrase used by central bankers to mean an increase in the interest rate.

The European financial markets had consequently reacted even before the actual increase. Prices of bonds had dropped, share indexes wilted and the euro hardened.

Inflation in Europe was not too high. In May it was a mere 1.9 per cent against the ECB’s own 2 per cent target. But the bank has always been cautious. Although the Euro Area has a common financial policy decided by the ECB, the conditions in different countries vary a good deal.

That is why France has been resisting increase in rates. During his election campaign the newly elected President Nicolas Sarkozy had vehemently criticized the ECB for the high rate and strong euro. Both had combined to bring down the rate of growth and increase the rate of unemployment.

In the past one year interest rates in most countries have been jacked up. In the United States, the rate has peaked at 5.25 per cent and is unlikely to be cut this year.

In the United Kingdom the short rate is at 5.75 per cent and in Australia at 6.5 per cent. Rates are in excess of 6 per cent in most Latin American countries and in many Asian countries except Singapore, Malaysia and Thailand. There is a general policy drift towards higher rates because economies have developed inflation bias.

That is even more true of India. There has been a 1.5 per cent increase in the interest rate by the RBI with the repo rate now at 6.0 per cent. Commercial banks were quick to raise the rates, both on credit as also deposits.

Apparently, however, inflation has galloped much faster than interest rates and, in spite of the recent fall in inflation, the real rate of interest (nominal rate minus inflation rate) is close to zero. It should be at about two.

Internationally, the upward drift in interest rates may continue. Trichet has warned that the inflationary pressure is still high and that the rate of interest may be kicked up again. September may be the time when another 0.25 per cent interest dose may be administered.

The impact will be a further increase in bond yield, a fall in share prices, and rise in the euro against the dollar. The expectation is that the exchange rate will cross $1.36 to the euro which has already appreciated 3.7 per cent since January.

With a further hardening of interest and euro, investment and exports will come up against a speed barrier and pull down the rate of growth and push up the rate of unemployment. Whether ECB will increase the rate of interest further critically depends on the future behavior of prices. But clearly, an increase in the ECB rate will have repercussions beyond Europe.