Interest Rates Within Euroland Might Now Vary From 4.2% To 8.7 % Had EMU Never Happened.

Business Editors

NEW YORK--(BUSINESS WIRE)--Sept. 28, 2000

The recent divergence of inflation rates within Euroland has put increasing strains on the "one size fits all" monetary policy implied by EMU according to a new study by economists at PricewaterhouseCoopers.

The analysis, published today as part of the firm's regular European Economic Outlook report, finds that, while growth rates have shown some signs of converging recently within Euroland, the opposite has been true for inflation rates. The study estimates the level of interest rates that might now be appropriate for the individual Euroland countries if they had not joined EMU but their central banks had continued to pursue the same inflation target in a credible manner. The authors conclude that:

- for Euroland as a whole, the analysis suggests an average interest rate of
just under 5% based on July 2000 inflation data; this would support the case
for some further rise in ECB rates from their current 4.5% level;

- the appropriate interest rates for individual Euroland countries vary widely
from 4.2% in Italy and 4.5% in Germany up to 8.7% in Ireland; this divergence
has increased significantly since the start of EMU after a period of nominal
convergence between 1996 and early 1999 (see table below for details);

- for Spain, the Netherlands and Finland, calculations suggest that interest
rates should be around 6% at present, raising fears of overheating unless
fiscal policy is tightened by more than is currently planned; and

- fears of overheating are most pronounced for Ireland based on the current
relaxed state of monetary policy in Euroland but, despite this, the Irish
government has not yet tightened fiscal policy significantly.

Rosemary Radcliffe, chief economist, PricewaterhouseCoopers Europe, commented, "Ireland is an interesting test case for whether a small, open economy can operate effectively within the "one size fits all" monetary policy implied by EMU. There is clearly some danger that relatively high Irish inflation could lead to a progressive loss of competitiveness and, possibly, an eventual asset price crash and recession. For the moment, however, the Irish economy remains strong and there is scope to expand the labor force through immigration and increased female participation in order to head off a wage-price spiral."

The PricewaterhouseCoopers analysis also considers the four EU countries currently outside EMU. It concludes that an adjustment to Euroland interest rates should not pose a problem for either Denmark or Sweden if they choose to join EMU. Greece, however, may face some short-term adjustment problems as interest rates need to be reduced rapidly to Euroland levels over the next three months at a time when growth is strong and Greek inflation, at 2.6% in July, is already running somewhat above the ECB's 2% target range ceiling.

The analysis also reveals that estimates of the appropriate level of interest rates for the UK is particularly sensitive to the definition of inflation used. The harmonized Eurostat measure currently suggests a UK interest rate of only around 5%, close to the Euroland average rate, whereas the RPIX measure broadly supports the current 6% level of UK interest rates.

The report also assesses the impact of energy price rises over the past year, concluding that these would imply that interest rates in Euroland need to be around 0.5% (50 basis points) higher than would otherwise have been the case to keep inflation under control.

"Economies are now less dependent on oil, but higher energy prices can still cause headaches for central banks because they imply both slower growth and higher inflation," said John Hawksworth, head of Macroeconomics at PricewaterhouseCoopers Europe and co-author of the study. "If Euroland interest rates are raised further to combat the inflationary impact of higher oil prices, the risk is that the still tentative economic upturn in Germany in particular could be put in reverse. In contrast, UK interest rates already seem to take account of oil price effects and do not need to be raised further at present."

Notes to Editor:

These estimates were produced using the so-called 'Taylor rule', which determines an appropriate level of interest rates based on an estimated neutral interest rate (assumed here to be 4.5% for Euroland, based on a 3% real interest rate and 1.5% expected inflation) that is adjusted for deviations in inflation from target and in GDP from its trend level. The rule is named after its originator, Professor John Taylor of Stanford University, and is widely used in economic models as a means of mimicking the behavior of central banks pursuing inflation targets.

1. Base case Taylor rule estimates for 1996 (pre-EMU), Q1 1999

(the start of EMU) and mid-2000 are set out below. Sensitivity

testing produces a range of around +/- 1% to 1.5% around these

central estimates for alternative plausible sets of input

assumptions.

    Taylor rule short-term interest rate estimates (%): base case

Country                      1996              Q1 1999       July 2000
Germany                       3.8                  3.3             4.5
France                        3.4                  3.4             5.1
Italy                         5.1                  3.4             4.2
Spain                         4.4                  4.4             6.0
Netherlands                   4.5                  5.1             6.2
Belgium                       3.5                  3.8             5.4
Austria                       4.4                  4.0             5.1
Portugal                      4.6                  5.0             5.5
Finland                       2.0                  4.2             5.9
Ireland                       4.0                  6.0             8.7

Euroland average              4.0                  3.7             4.9
Standard deviation            0.9                  0.9             1.3

Greece                       13.5                  6.5             6.1
Denmark                       4.9                  4.7             5.2
Sweden                        3.0                  3.2             5.1
UK (using HICP)               4.9                  4.9             4.8
UK (using RPIX)               5.8                  4.9             5.9

      Source: PwC estimates using the Taylor rule with Eurostat
harmonised inflation data (except for the UK RPIX case) and OECD
output gap estimates. In the case of Greece, actual inflation is taken
as a proxy for expected inflation. In other countries an inflation
target of 1.5% is assumed using the harmonised Eurostat measure (or
2.5% on the UK RPIX measure).

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