Euro-zone economies face a growing challenge in 2005 as the euro continues to strengthen against both the dollar and sterling and ECB interest rates rise by half a percentage point, according to Ulster Bank Financial Markets.

In its 2005 outlook the bank says the dollar is likely to weaken to around $1.42 during the year from its current level of around $1.36.

"We base our call primarily on the worsening outlook for America's notorious current account deficit," said Mr Niall Dunne, the bank's financial markets strategist. "To tackle this deficit, America's Federal Reserve is intent on engineering a dollar decline."

From Europe's perspective, Mr Dunne notes that a managed dollar decline might be the lesser of two evils. "Any further deterioration in America's current account deficit could, in the words of the Fed, lead to a 'rapidly depreciating dollar and rapidly rising interest rates'."

But he acknowledges that it is hard to take any comfort in that at a time when the weak dollar is lifting the euro to levels that "threaten to derail the euro-zone's stuttering economic recovery".

Mr Dunne dismisses the prospect of intervention although he expects more vociferous "verbal intervention" that could leave the euro trading in a $1.30-$1.35 range over the next few months.

The Ulster Bank Outlook also predicts a rise in the euro against sterling, the other major currency for Ireland's export markets.

"UK economic growth is expected to slow next year and, just like the US, the UK is facing a growing balance of trade deficit," Mr Dunne writes.

He says the recently recorded trade deficit in fuel - the first recorded since 1991 - is a particular concern and see the euro move ahead over the year to challenge 72 pence. It is currently trading at 70.9 pence against the UK currency.

Interest rates in the euro-zone are likely to rise, tracking similar movements the far side of the Atlantic, Mr Dunne believes. He forecasts that US rates will hit 4 per cent by the end of the year, up from the current level of 2.25 per cent and ahead of general expectations as inflationary pressures feed through to consumers, triggering a demand for higher wages.

In the euro-zone, Mr Dunne expects the rise in rates to be less dramatic, forecasting a half percentage point increase over the year to 2.5 per cent, again on the back of inflation fears driven by rising commodity costs, despite the "anaemic" economic growth within the bloc.

"Given the strength of the euro, further anticipated dollar depreciation and the weak economic outlook for Europe, it would probably be premature to expect a rate hike in early 2005," Mr Dunne writes. "Yet given the ECB's stated views on inflation and our suspicion that the governing council feels uncomfortable with rates at current accommodative levels, we think the ECB will act in the second half of 2005.

Also writing in the outlook, Ulster Bank chief economist Mr Pat McArdle reiterates his growth forecasts for the Irish economy of 4.25 per cent and employment growth of 4.75 per cent.