ECONOMICS: Even a fairly modest rise in interest rates in Europe and the US later this year would be a sign that world economy had returned to better health

With a little luck, interest rates will be on a clearly rising trend later this year. It may seem strange to suggest that higher interest rates could possibly be good news, but rising rates would signal that the global economy was set on an improving trend. After the many concerns of the past year, that would be a very encouraging outturn.

We should remember that a falling rate environment has been a feature of a moribund Japanese economy since 1991. Indeed, Tokyo money market rates have been close to zero since 1995. So, a modest rise in interest rates in Europe and the US would be a healthy sign of renewed vitality in these economies.

If interest rates don't rise, it will probably be because the world economy suffers a serious setback. At present there is considerable nervousness that a worsening situation in the Middle East could threaten an upswing that is still in its infancy. If oil prices were to move above $30 (€34) per barrel and remain there for any length of time, growth would be hurt and inflation higher. On very rough estimates, I reckon Irish GNP growth could be around half a percentage point lower than my current forecast of 3.5 per cent. Less robust economies could be hit even harder.

Sharply higher oil prices would pose problems for central banks. Because growth would suffer, there could be a clamour for lower interest rates. History urges caution. An aggressive policy-easing in response to soaring oil prices in the 1970s did not prevent a significant weakening of economic activity but it did contribute to runaway inflation.

With a little good fortune and a large measure of common sense, it may be possible to avoid the worldwide political and economic damage that a further escalation of hostilities in the Middle East threatens. The shadow it now casts on economic prospects makes it unlikely that we will see an early rise in interest rates in Europe. If and when concerns about oil prices fade, the European Central Bank will quickly begin to debate the timing of a first rate hike.

There are several reasons why the ECB might not delay its first step towards higher rates. It is probably uncomfortable that the current level of official interest rates is unusually low because of the "emergency" easing that came in the aftermath of September 11th.

As an upturn becomes increasingly evident, many at the ECB will be anxious to hurry rates higher to what might be regarded as more "normal" levels. This mindset could also be shaped by a judgment that rates went too low and stayed there too long in 1999, with the result that inflation has been above target for most of the ECB's brief history.

The relatively upbeat tone of several recent ECB comments could be a further pointer towards future rate rises. Although the broad sweep of euro area data has not been as robust as comparable US numbers, central bankers on this side of the Atlantic have been a great deal more confident in their pronouncements on the economic outlook than their counterparts at the US Federal Reserve.

Unfortunately, that optimism sits uneasily with a still fairly pessimistic assessment of the implication of stronger activity for inflation. ECB officials have repeatedly emphasised that the euro area economy will grow in line with potential by the end of this year. The suggestion that the economy will quickly reach "full steam" could be interpreted as a veiled threat that interest rates will soon need to rise.

Although I feel the coming recovery may not be as brisk as the ECB expects, and I would not regard solid growth as particularly worrisome in terms of an inflation threat, the Bank's concerns are understandable. Its track record on inflation is not particularly impressive. The 2.5 per cent rise in consumer prices in the year to March means inflation has been clearly above the ECB's target for 22 consecutive months.

There is a strong likelihood that euro-zone inflation will edge below target in the next month or two but any subsequent improvement is likely to be limited both in degree and duration. By late summer, inflation could be moving higher. Ample spare capacity in the euro area and elsewhere in the world economy should prevent a sharp deterioration in inflation, but the ECB may be keen to guard against such a possibility by raising interest rates.

The old adage that a stitch in time saves nine is particularly relevant to central bank policy. Even fairly modest increases in interest rates in the second half of this year and the early part of 2003 should prove sufficient to take the sting out of inflation fears while allowing economic activity to remain on a improving path.

I don't expect dramatic increases for the foreseeable future. ECB rates could be around three-quarters of a percentage point higher at 4 per cent by the turn of the year and might peak in 2003 around 4.5 per cent. In these circumstances, headlines proclaiming higher interest rates later this year should not be regarded as threatening. Rather, they would suggest that the world economy had returned to good health.

Austin Hughes is chief economist with IIB Bank