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Weak interest rates forecast until 2003 Back  
Aziz McMahon, treasury economist at Ulster Bank Group Treasury
Short term euro interest rates are heading lower, chiefly because of a rapidly improving inflationary environment in the euro zone. Despite a weakening growth environment, the ECB was prevented from cutting interest rates earlier in the year by an unfortunate coincidence of higher energy and food prices which, together with a weak exchange rate, drove inflation well above the ECB’s 2 per cent target ceiling to a peak of 3.4 per cent in May. By having to delay rate cuts because of the inflation spurt, the ECB fell behind the curve. In an effort to catch-up, the ECB cut rates for the first time in this cycle on 10th of May citing an unexpected downward revision to the first pillar of monetary policy money supply growth. The next cut on 30th of August was based mainly around a more benign view of the medium term inflation outlook, while the 50bps cut on 17th of September, while ostensibly a reaction to the US terror attacks, was arguably the last part of the catch-up process.

We expect the ECB to cut rates to 3.0 per cent from 3.75 per cent by February 2002 with the next cut likely to come this month following the publication of excellent September inflation data. The year on year HICP inflation is likely to fall from 2.7 per cent in August possibly as low as 2.2 per cent in September or October. September 2000 saw sharp increase in energy prices, so even on an assumption of a constant $26pb oil price the year on year comparison was likely to fall to 2.3/2.4 per cent in September. However, following the terror attacks the oil price has actually fallen by 20 per cent which in combination with a more stable exchange rate, should see inflation fall even further. We expect Euro zone inflation to fall to around 1.5 per cent in the first quarter of 2002.

Money supply growth is likely to be above target until Q1 2002 at the earliest, however, this should not deter the ECB from cutting rates.

While we expect rates at the short end of the maturity spectrum (out to 1 years) to fall by a little more than the market currently expects, we also expect to see a simultaneous rise in rates further out the curve. Much of the upward pressure on longer term rates is likely to emanate from the US bond market where massive fiscal stimulus is likely to increase Treasury bond issuance and drive yields higher from the 2 year area out. Consequently we believe the current environment presents a great opportunity for borrowers to lock into historically low long term rates.

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