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Tuesday, May 24, 2005

OECD Advocate ECB Rate Reduction

At market closure in Europe today the difference in yield between German 10-year bunds and their U.S. equivalents was 73 basis points, more or less a one-month low. Analysts suggest that investors are scaling back expectations the Federal Reserve will keep raising its main rate to counter the threat of inflation as the European Central Bank keeps its rate unchanged - ie most of the weight is being put on the fact that inflation expectations are low. I can think of another reason Alan Greenspan may have to thing more than once about proceeding with rate rises in the US: rates not only may not rise in the eurozone, they may in fact fall, and if they do any appreciable increase in the Atlantic spread could precipitate a rise, not a fall, in the value of the US dollar.

In fact the OECD today recommend that the Federal Reserve should continue to raise U.S. interest rates, while the European Central Bank should ease eurzone monetary policy. These recommendations come in the OECD semi-annual Economic Outlook out today. The OECD's eurozone growth forecasts of 1.2 % for 2005 and 2.0% for 2006 are based on the assumption that the ECB, which has maintained its core refinancing rate at 2.0% since June 2003, will cut rates by half a percentage point in mid-2005.

With domestic demand sluggish, resilience feeble and possible upward pressures on the euro looming ahead, the balance of risks on growth and inflation is clearly tilted to the downside, calling for an early easing of monetary policy”.

And why does the US need to keep raising rates: well todays housing data would be one of the reasons. So what I am saying is that Greenspan is increasingly likely to find himself between the proverbial rock and the hard place. Domestically he needs to keep rates moving up, but in terms of the deficit and the international competitiveness of the US economy, he needs to keep them low.

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