Europe raises stakes in rates race

The stakes have been raised in the great global interest rate race. The Europeans have cranked up rates by half a per cent, following the recent lead of the Americans. Britain has stopped for a comfort break, encouraging industrialists' hopes that it might be about to drop out of the running altogether.

The European Central Bank's decision to raise rates from 3.75% to 4.25% caught markets on the hop. Most observers were anticipating only a quarter per cent rise - in line with the three previous increases. But surprise is traditionally the most powerful weapon in central bank armouries.

The ECB's move must be considered in the context of the US Federal Reserve's half per cent increase in official rates last month. At that time the euro was declining at an alarming rate, exacerbating the ECB's fears of future eurozone inflation. The wider the interest rate gap between America and Europe, the more remote a euro recovery, the greater the inflation risk.

The foreign exchange market hosted a modest rally by the euro between the US and European rate rises. This was based on a feeling that the Fed had delivered ample medicine to the US economy and that all rate action would now be in Europe. Over to you, Wim & Co.

One suspects that the ECB took a look at the euro's rally and decided to give it a helpful extra shove by surpassing the market's rate expectations. One can only imagine their response to the markets' reaction to the latest rate rise. After an initial increase the euro swiftly reversed its gains to close flat on the day. But then, if central bankers live to surprise, markets live to confound expectations.

The relationship between monetary authorities and foreign exchange markets is akin to that of puppeteer to puppet. The problem is, it's rarely clear who's in control of the strings. Just ask Norman Lamont and George Soros for their respective versions of the pound's October 1992 departure from the exchange rate mechanism.

While the European authorities are right to worry about the economic consequences of a weak currency - after all, that's what they're paid to do - there's little sign that price pressures are becoming a significant threat in the core economies of the continent. But the same could be said of the US and the UK where interest rates have also been rising.

This upward trend in the cost of money has been a major constraint on the performance of global equity markets. Dearer money creates more attractive alternatives for investors - fixed income products and cash on deposit. It also depresses company profits, reducing their investment appeal.

To date it is the first of these two influences that has weighed on stock markets. Bonds have produced a 3.3% return for investors this year, equities 1.9%, while dollar investors have suffered negative returns from both bonds and equities.

Around the world companies are not weighed down by the debt on their balance sheets. The painful lessons of the late 1980s, when soaring interest costs crippled over-borrowed companies, are still remembered. So rising interest rates should not generate many profit shocks.

A policy-induced slowdown in overall economic activity, however, could be damaging. In a world of low inflation, businesses boost profits through a combination of cost-cutting and volume growth. Choke off the benign influence of economic growth on sales and many companies will struggle.

At this stage of its economic cycle, continental Europe is unlikely to be knocked off its growth path by higher interest costs. The UK, on the other hand, is further through its cycle.

The monetary policy committee has decided that - for now at least - the combination of dearer money and a strong currency is slowing growth.

Industrialists have been squealing about the impact of strong sterling for months. Official statistics on industrial production bear out their concerns.

The service industries are more buoyant, but indications that house price inflation has slowed will carry weight with the MPC. Interest rate increases only grip economies with a lag. In the UK their impact is now being seen.

It's conceivable that, by the year end, European and UK interest rates will have converged at or slightly below Britain's current 6%. That would likely spell a cheaper pound. Bad news for British machismo, but good news for the stockmarket.

• Edmond Warner is chief executive of Old Mutual Securities