| Weak euro produces lax monetary environment in Ireland |
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| John Beggs considers Ireland's experience with the Euro and says that the benefits of membership should not be judged on the basis of the performance to date. |
Ireland’s experience as a member of the eurozone has attracted a great deal of attention in the UK where the eurosceptics see Ireland as a test case of the ‘one size fits all’ monetary policy. The UK view of Ireland is that the economy is overheating Sustained exceptionally strong growth in real GDP of 8-10 per cent a year now goes hand in hand with high inflation. Most external commentators see a direct link between the strength of the economy and the sharp acceleration in inflation since the latter part of 1999. However, the fall in the value of the euro has played a key role in pushing Irish inflation to over 6 per cent.
Despite the concerted central bank intervention to support the euro, the currency remains well below its equilibrium level, with no immediate prospect of a strong recovery.
The weakness of the euro since its launch in January 1999 has helped to offset any deterioration in Irish cost competitiveness in national currency terms. However, it has also added significantly to Irish inflation and created difficulties for the continuation of the Programme for Prosperity and Fairness. Eurozone interest rates have been on the rise since November 1999 but the current level of the official minimum refinancing rate at 4.5 per cent is negative in real terms as measured by the Irish consumer price index or the manufacturing output price index. In overall terms, therefore, monetary conditions remain extremely accommodative by Irish standards. Some tightening of monetary conditions are envisaged over the next year. Eurozone interest rates are expected to rise by 0.5 per cent to 0.75 per cent while the euro should appreciate slowly over the next 12 months.
The sustained weakness of the euro and its impact on Irish inflation, along with the effects of higher oil prices, illustrate the difficulties of the ‘one size fits all’ monetary policy within the eurozone. Some commentators have argued that interest rates at 10 per cent or more would be more appropriate to Ireland at this stage of the economic cycle.
In his address to the Financial Services Industry association (FSIA) in Dublin in September, the ECB President, Wim Duisenberg, stated that Ireland was enjoying a free ride given the low level of interest rates in the eurozone and the current strength of the Irish economy. With the current inflation difficulties facing the economy, it is easy to say ‘we told you so’ in relation to Ireland joining the euro with a very different economic structure to the rest of the eurozone, and without its major trading partner the UK.
What would have happened to Irish interest rates and the exchange rate had Ireland decided to remain outside the euro in 1999? Presumably, we would have sought either a narrow or broad band arrangement with the euro, similar to the Danish arrangement, within the context of ERM2. This would have involved a margin of fluctuation around our ERM central rate of DM 2.4833. Bands of 15 per cent would have given the Irish pound an upper limit of over DM 2.85. If the Irish pound was capped at the top of its permitted range against the DM at DM 2.85, this would have translated into an IEP/GBP rate of STG 0.87, based on the current level of EUR/GBP. The Irish pound would also be trading at $1.28. However, it is possible that pressure would have mounted on the Irish pound to move above its upper limit, within ERM2, thus resulting in an appreciation of the IEP towards parity with sterling and a rise in the IEP/USD rate to above $1.40. The trade weighted value of the Irish pound would be about 25 per cent higher than at present. Such a rise in the Irish pound would have reduced the necessity for higher interest rates in Ireland. Of course, rates would not have fallen at the end of 1998 and may have risen by 1-2 per cent towards 7.5 per cent - 8.5 per cent outside of EMU. The Irish economy would have expanded at a slower rate in 1999 and 2000 due to tighter monetary conditions but the main emphasis would have been on the appreciation of the currency rather than on the need for significantly higher interest rates.
Irish Monetary Conditions to Tighten in 2001
So much for what might have been. Ireland is a member of the euro and the process is irrevocable. The benefits of euro membership cannot be judged on the basis of the short trading period to date. Ireland joined the euro in the belief that being part of the new currency zone would help to consolidate the low inflation environment which existed in Ireland throughout the 1990’s. The result so far has been disappointingly. The ongoing weakness of the euro threatens the restoration of a low inflation environment, in Ireland. Fiscal and incomes policies alone cannot produce a significant downturn in the Irish rate of inflation. A recovery in the euro will have the most dramatic impact on Irish inflation. With a rise in the exchange rate and a fall in the Irish rate of inflation, the level of real interest rates in Ireland will also rise, thus exerting a double, but manageable, tightening of Irish monetary conditions. |
John Beggs is Chief Economist at AIB Group Treasury.
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| Article appeared in the October 2000 issue.
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