How low will interest rates go - and how quickly will they fall? Last week's 1.25 percentage point cut in the Central Bank's key money-market rate surprised mainly by its size, if not its timing. But the real question is how low will our rates actually have to go - rather than the timing of the Bank's cuts to the end of the year.
It used to be assumed that base money-market interest rates would fall to around 4 per cent by the end of the year, as the Germans would increase their rates from existing levels. Recently, as the international growth outlook worsened, it was expected that short-term market rates here would fall to 3.3 per cent, on the assumption that German rates would remain at current levels. But there is now talk of base euro rates falling to 3 per cent within the first six months of next year.
Of course, the global economic crisis has had much to do with this. Calls are emanating from sources such as the International Monetary Fund and the US Federal Reserve - among others - for lower global interest rates to head off the crisis.
But another key development is the switch to social democratic governments across Europe. The new German finance minister, Oskar Lafontaine, appears very close to the French on many monetary policy issues. And most observers agree that the new centre-left governments across Europe are all more likely than their predecessors to try and put pressure on central banks to cut interest rates.
Even British Chancellor, Gordon Brown, who has only just given the Bank of England independence, has recently been piling pressure on the Monetary Policy Committee (MPC) of the bank, which sets interest rates. At the recent IMF annual meeting in Washington, Mr Brown made it clear he expected rates to fall, although he emphasised that this was, of course, a matter for the MPC. He also announced that the Treasury would cut its forecast for GDP growth in 1999 from its current level of between 1.75 per cent and 2.25 per cent. But he did not mention by how much he would cut.
There are already people questioning his statement in May 1997 when he declared that giving the Bank of England control over interest rates would "ensure that decisions are taken for the long-term interests of the economy and not on the basis of short-term political pressures." The MPC, of course, did the decent thing and cut British rates by a quarter of a point.
At the same time, there are many who are watching with interest the likely reaction of the new European Central Bank president to pressure from many of the euro eleven's leading politicians. Germany's new Chancellor, Gerhard Schroder, as well as the government elected last year in France, both appear to believe in using monetary policy to some extent to help with unemployment.
Mr Lafontaine, who appears most likely to be the new German finance minister, has already been talking of exchange-rate targets and the need for a political counterweight to the European Central Bank (ECB) as well as the importance of the dollar and yen exchange rates.
For many of Europe's politicians, unemployment is naturally almost more important than inflation control, particularly if it only means a smallish uptick in prices.
But central banks do not believe this. And there are many who fear that the ECB may even try to prove that is tougher than the Bundesbank when it comes to making policy decisions. It has not yet said whether it will use inflation or monetary targeting when setting interest rates, but one thing is for sure - unemployment will not be one of the key variables it watches.
Even without the political counterweight which some governments are looking for, the politicians do have one trick up their sleeve, as Davy's chief economist, Mr Jim O'Leary, points out. Under the Maastricht Treaty the politicians have control of exchange-rate policy. And that is central in setting the overall direction of monetary policy - the combination of interest rates and exchangerate management.
Already individual central banks such as the Bundesbank and the Italian central bank are coming under pressure from politicians and indeed many economists to cut rates, in a bid to bolster the outlook for the world economy. But so far, Dr Hans Tietmeyer, Bundesbank president, is hanging onto the notion that the rate cuts seen in Spain and even Portugal and Ireland last week are enough for the moment. He argues that the eventual convergence of those countries' rates, along with Italy will amount to a 0.5 percentage point fall overall in euro-zone interest rates rates. At 3.3 per cent, they are already well below the prevailing rates in the US at 5.75 per cent and Britain at 7.25 per cent.
They also argue that there is no point cutting short-term interest rates, if the result will only be a rise in longer term rates as the central bank's inflation credentials come to be questioned.
Dr Tietmeyer believes he should only respond if financial instability and weaker demand abroad are likely to affect domestic growth and inflation. The IMF is still forecasting euro-area growth of 2.8 per cent next year, the highest among the main economic blocs, so on that basis there is little reason for a German rate cut.
But the other problem is that cracks in the European economy are beginning to appear, as many EU central bankers seemed only to be beginning to realise in Washington last week. Exports to Asia and Russia have of course fallen, EU banks have lost big money in emerging markets. According to the Economist, European bank loans to emerging economies amount to around 7 per cent of the region's GDP, while the equivalent figures for US banks is only 1.5 per cent.
On balance, the most likely result would appear to be euro starting rates of 3.3 per cent and a possible rate cut next year, depending on the state of the EU economy and how quickly any negative impact from Asia is feeding through. Other likely important factors will be the dollar exchange rate. According to Mr O'Leary a fall in the dollar rate to DM1.50 or DM1.55 from a current DM1.6340 will mean a likely rate cut, to avoid too sharp a rise in the euro against the US currency.
He adds that it is very difficult for any central bank to operate in a political vacuum. And that the notion of a central bank's independence is conditional upon it having a mandate which politicians respect and also on their being successful.
At the very least, the politicians can put the central banks under pressure, meaning that the banks - including the new European Central Bank - have to defend their policies more rigorously and to confront the fact that there is an alternative view. Admittedly, the Bundesbank rarely had this experience, as it was only brave or foolish politicians who tried to criticise it. But the ECB will be facing pressure from all corners of Europe and the problem is that without a track record it must be more susceptible to political pressure.
The bottom line is that if it faces a chorus of political demands from across Europe to cut interest rates, then it will in the end be more likely to oblige. Although there is still every chance that the EU recovery is robust enough to remain on track and that tweaking of monetary policy will be all that is needed to keep a reasonable level of economic growth on track.
