The European Central Bank (ECB) has warned the Government against using increased tax revenues to boost public spending and pointed to the need for budgetary policy to be used to combat inflation. Its president, Mr Wim Duisenberg, has also said that Irish interest rates must fall sharply to the levels now prevalent in Germany and France by the end of the year.

Speaking at a press conference in Frankfurt following a meeting of the bank's governing council, Mr Duisenberg revealed that the council was concerned about the danger of overheating in the Irish economy.

"We did discuss it. We note that in the run-up to the introduction of a single monetary policy, fiscal policy will have to take the place of national monetary policy", he said. "Interest rates must come down in the direction of the best performing countries. I would expect that to happen during the next five months".

Mr Duisenberg named Ireland and Italy as the two European Union member-states which need to cut interest rates most urgently and identified Ireland as the most seriously out of line.

He said that a remarkable level of convergence had been achieved in long-term interest rates during the past 12 months. But short-term rates remained a problem.

"There are two countries . . . Italy and Ireland. There is some way to go particularly in the latter case", he said. Mr Duisenberg expressed general satisfaction with economic development within the euro area, characterising the picture as one of continued economic expansion combined with broadly low inflation.

But he insisted that any "growth dividend" in the euro states resulting from the upturn should be used to bring deficit and debt levels down rather than cutting tax or increasing public spending.

"What action is taken depends on how much room there is for manoeuvre. For increasing government's expenditure, there would seem to be little or no room at all", he said. Mr Duisenberg said that the governing council discussed monetary developments at Tuesday's meeting and was pleased with the stability of exchange rates within the euro area.

"There is currently no sign of exchange rate tensions among euro area currencies. Forward exchange rates are expected to be virtually identical to central rates suggesting that the pre-announced rates are considered credible. I consider this a remarkable achievement," he said.

The governing council, which is composed of representatives from national central banks within the euro area, was meeting for only the second time since the ECB was set up. The bank also laid out the broad lines of its strategy for the future euro zone, including minimum reserve requirements for commercial banks and the level of its gold reserves.

It said that the ECB would hold about 15 per cent of its reserves in gold out of a total 39.46 billion euros in exchange reserves to be initially transferred to the ECB by the 11 countries to join in January.

Mr Duisenberg also said the ECB would set minimum reserve requirements for commercial banks in the euro single currency zone, forcing commercial banks to deposit a certain percentage of their deposits with the central bank involved.

Banks will have to set aside between 1.5 and 2.5 per cent of certain deposits, but will receive interest on the money.

However, banks complain that a minimum reserve requirement damages their competitiveness against banks in countries outside the euro zone, such as Britain, which imposes no reserve requirement on commercial banks.