OBSERVER: With the US recession probably over and the ECB talking up recovery in Europe, current fixed-interest mortgages begin to look like good value

OBSERVEThe US recession is probably over and the current quarter is likely to see a return to positive growth, with a stronger acceleration as the year progresses. Uncertainties remain but if the economic cycle is turning then so too is the interest rate cycle and borrowers may face the prospect of higher interest rates in 2002, with rates rising as early as the second quarter in the US and Britain, although the Irish economy may be spared till later in the year.

Interest rates certainly tumbled in 2001. The US Federal Reserve started cutting in January, when the Fed funds rate stood at 6.5 per cent and ended in December at 1.75 per cent.

In Britain also rate cuts were unusually aggressive, with the repo rate down to 4 per cent from 6 per cent at the beginning of the year. The European Central Bank (ECB) came late to the party and with less enthusiasm; the repo rates in the euro zone fell from 4.75 per cent to 3.25 per cent.

For some, further rate cuts are not out of the question, and Mr Alan Greenspan, chairman of the US Federal Reserve, seemed to leave the door open for another cut in a speech last weekend, when he referred to the "downside risks" facing the US economy, albeit one where the signs of recovery were deemed to be present.

Most of the other members of the Federal Open Market Committee (FOMC), which sets US interest rates, appear to disagree and it is not clear whether Mr Greenspan will be able to deliver one final rate cut at the next FOMC meeting at the end of January.

One suspects not, because the signs of recovery are growing; manufacturing orders surged in December, consumer confidence has risen for two consecutive months and profit upgrades are not as rare as they were in the corporate sector.

The consensus is now busily revising up US growth prospects for 2002, with a positive GDP reading now expected in the current quarter. Indeed, consumer spending was so strong in the fourth quarter of last year, buoyed by a surge in auto sales, that some analysts are now looking for a positive GDP reading for that quarter. If so, this would mean that the US actually avoided a recession, at least in the technical sense of two consecutive quarters of negative growth.

The majority view remains that GDP shrank by around 0.3 per cent in the quarter, following a similar fall in the third quarter, which would represent the mildest recession in modern US history.

The issue now is the likely strength of the upturn. The degree of monetary easing argues for a decent bounce in growth, particularly as the money supply has surged in recent months, which is normally a good leading indicator of economic activity.

The equity market too has risen appreciably from its late September lows, as investors bet on a rebound in company earnings.

If growth does take hold, the Fed will begin to unwind last year's rate cuts, possibly as early as May, and the Fed funds rate may well be back up to 3.5 per cent or so by the end of 2002. In Britain, the market is expecting the next interest rate move to be upward as consumers have gone on a borrowing and spending spree.

From an Irish perspective, there is still a chance that rates could fall further in the short term before rising again later in the year. The signs of an economic recovery in the euro zone are not as clear-cut as those in the US, and the German economy is probably still in recession, which argues for further monetary easing.

The case for lower ECB rates is supported by the near-term outlook for inflation, which is likely to fall towards 1.5 per cent and below in the next three months.

Unfortunately, the recent rhetoric from ECB officials is not reassuring for those looking for further easing; council members have been talking up the recovery, and hence dampening expectations for further rate reductions.

The markets also are no longer anticipating further cuts and are now expecting a repo rate of 3.75 per cent by year-end or half a percent higher than the current rate. Irish mortgage-holders may therefore want to look at fixing borrowing rates to protect themselves from a rise in mortgage costs. Three-year rates are currently on offer at below 5 per cent, which is attractive and may not be around for much longer.

• Dr Dan McLaughlin is chief economist with the Bank of Ireland