With the holiday season drawing to a close, financial market activity should move up a gear in the weeks ahead. The euro faced a difficult period over the summer months as the markets, albeit in somewhat thin conditions, continued to favour the US dollar.
The US Federal Reserve left official interest rates unchanged this week. The conclusion to be drawn from this stance is that Fed is fairly comfortable with the evolving US economic picture and sees the economy heading for a soft landing.
Barring any unexpected inflationary shocks therefore, it would appear that US official interest rates are on hold for the foreseeable future.
Attention has now switched to the European Central Bank, which will meet on Thursday next after its holiday break. With inflation running at 2.4 per cent in the euro zone and the weak euro and high oil prices posing a risk of a further acceleration in inflation, the ECB is poised to raise official rates in the near term. This could come as early as next week or when the ECB meets on September 14th, which will be followed by a press conference.
Rates seem set to rise by at least a quarter of a percentage point and more probably by half a percentage point.
This may not be the peak before the end of 2000. This week's weaker than expected German Ifo survey will raise doubts about the sustainability of Germany's economic recovery. However, for the euro zone as a whole, growth remains strong and the ECB is more focused on the inflation data than on economic sentiment indicators.
From an Irish perspective, higher euro interest rates may be seen as good news in that eurozone monetary conditions are currently too accommodative for Irish economic circumstances.
However, with the focus firmly on Irish inflation, the effect of higher euro interest rates will be to add up to half a percentage point to the Irish consumer price index (CPI) in coming months.
Furthermore, if the euro were to weaken from current levels, out of concern for euro area growth prospects due to excessive interest tightening by the ECB, Irish inflation would worsen due to higher import costs. This would be on top of reports that the price of many imported goods from the UK is set to rise in the autumn, based on the current level of the euro against sterling.
Before the end of 2000, therefore, the Irish rate of inflation will accelerate sharply from the current rate of 6.2 per cent.
The Government's initiative in blocking public sector price increases, which traditionally impact in the August to October period, may be sufficient to prevent the Irish CPI from rising above 7 per cent before November. However, with the effects of last year's tobacco tax increase falling out of the annual rise in the CPI in December, the annual rate is unlikely to dip below 6 per cent at the year end . For 2000 as a whole, the average rate of inflation is expected to be 5.6 per cent, compared with 1.6 per cent in 1999.
The rise in inflation towards 7 per cent will further fuel the domestic and international debate about the "overheating" Irish economy and the appropriateness of the "one-fit-all" interest rate policy for the euro area.
Ireland's experience is being monitored very closely in Britain. The IMF in its recent report on the Irish economy stated that Ireland found itself at the cutting edge of the debate over the risks and policy challenges facing small, cyclically advanced economies in the euro area. Irish economists are finding it increasingly difficult to persuade a sceptical domestic and international audience that the strength of the Irish economy is not the major cause of Irish inflation. The concurrence of sustained strong economic growth and the rise in Irish headline or published inflation from annual rates of about 1.5 per cent - which persisted over the first 10 months of 1999 - to the current figure of 6.2 per cent in July, does not imply causation.
Of the 4.7 percentage point rise in the annual headline rate of inflation between October 1999 and July 2000 (i.e. from 1.5 per cent to 6.2 per cent), higher ECB interest rates, higher oil prices, euro weakness and higher indirect taxes accounted for a swing of 3.5 percentage points. This is almost 75 per cent of the total acceleration.
Higher food prices, which largely reflect the effect of seasonal factors and higher import costs, also added an additional 0.3 percentage point. This does not leave much room for the impact of "overheating" on inflation. The acceleration in services inflation over the period added another 0.3 percentage points to the upturn in inflation.
Taking all the other CPI categories and attributing their higher contribution to the rise in inflation to the strength of the Irish economy accounts for less than 20 per cent of the total pickup in the CPI since last October. This overstates the "booming economy" effect, as many other CPI commodity groups, apart from food and energy, also contain a high percentage of imported goods.
The bulk of Ireland's higher inflation rate is imported. There is no denying that Ireland's membership of the euro has impacted negatively on Irish inflation to date, particularly via the exchange rate.
Irish strategy in joining the euro was to be part of a firm or hard currency area, which would consolidate the low inflation environment that existed in the 1990s. So far, however, the euro has been weak, threatening Ireland's fabled combination of high growth and low inflation.
Unless the euro recovers, the Irish rate of inflation will remain excessively high over most of 2001. Based on trends to date in 2000 and assuming that eurozone interest rates rise to 5.5 per cent in 2001, but that the currency stages a recovery to over parity with the US dollar in the course of next year, the average rate of inflation in Ireland in 2001 is set to top 4 per cent.
