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Weak interest rates forecast until 2003 Back  
Oliver Mangan, AIB Treasury and International, FX & IRM Dublin, AIB International Centre
Ireland, Euroland and indeed the global economy are in the grip of a marked downturn in economic activity, a downturn that is likely to increase in momentum as a result of the terrorist attacks in the US last month. The ECB cut rates by 0.5 per cent in the aftermath of the attacks, in line with the US Fed. This brought the total reduction in Euroland interest rates year to date to 1 per cent with the key ECB refi rate standing at 3.75 per cent by end September.

With inflation now in sharp decline in Euroland, and the economy set to continue growing well below trend , the ECB is likely to cut rates by another 0.5 per cent over the balance of the year. Should the downtrend in activity extend in to the early part of next year, then a further 0.25 per cent rate cut is likely, taking the refi rate down to 3 per cent.

The marked loosening of monetary policy globally, combined with more expansionary fiscal policies and declining oil prices should set the stage for a global upswing in activity over the course of 2002. However, with inflation likely fall below the key 2 per cent ceiling level next year, the ECB should not be in any rush to start tightening policy. Thus, rate increases in response to stronger growth in 2002 are unlikely to materialise until late in the year. If, indeed, a sustained upswing in activity does get underway next year, then the key refi interest rate is likely to be increased to close on 5 per cent during 2003/2004.

This year has seen a pronounced steepening of the yield curve. Yields on longer dated bonds fell sharply last year in anticipation of the economic slowdown and thus have been quite stable to date in 2001. Yields on shorter dated bonds though, have fallen significantly this year as the extent of monetary easing has been far greater than originally anticipated. There was a particularly sharp decline in short dated yields in the aftermath of the terrorist attacks in the US.

Bond yields are likely to remain low over the next couple of quarters with economies close to recession, stock markets in a nervous state, inflation in decline and further rate cuts in the pipeline. Yields, though, can be expected to rise quite sharply over the course of 2002 if, as seems likely, economic growth reaccelerates. The rise in yields should be most pronounced at the short end of the curve on fears of monetary tightening, Thus, the slope of the curve should flatten considerably next year. This trend is likely to continue in 2003.

At the retail end, further declines in variable interest rates are in store over the coming months and rates should stay low for most of next year. Fixed-term rates have been slower to fall as institutions wait to see whether or not the recent declines in short dated bond yields prove sustained.

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