Comment:Irish consumer prices fell in July, according to data released by the Central Statistics Office (CSO) yesterday. For the first time in six months, the consumer price index recorded a fall as retailers cut prices during summer sales, writes Niall Dunne.

Yet the overall CPI index would have risen, despite the generous retail discounts, had oil prices not fallen during July.

According to the CSO, Irish petrol prices fell by 2.2 per cent last month, as the international oil markets stabilised.

Had petrol prices not fallen during the month, the beneficial effect of retail discounts on the CPI would likely have been negated. However, the trend of falling prices is unlikely to continue in August.

On average, oil traded at $40.81 on the New York Mercantile Exchange in July. In the first two weeks of August, the average price paid by traders has risen to $44.24. Crude costs have risen by 8.5 per cent per month to date, and petrol retailers will inevitably pass rising costs on to consumers in the weeks ahead. That is why consumer price inflation will likely rise again in August, both in Ireland and globally.

Yet the financial markets seem uninterested in inflation. Despite the reality of rising oil prices, recent comments from the Bank of England and the American Federal Reserve have calmed traders' nerves.

Last Tuesday the Federal Reserve's open markets committee voted to raise American interest rates by 0.25 per cent, taking base interest rate in the United States to 1.50 per cent. Despite the combination of record high oil prices and exceptionally accommodative monetary policy, the Fed stated that "the upside and downside risks to the attainment of price stability are roughly equal".

The Fed are content that underlying inflation - the inflation rate excluding volatile food and energy components - remains "relatively low", and on that basis they remain sanguine about the "transitory" nature of recent "elevated" prices.

Attention then switched to London on Wednesday morning, as the Bank of England released its latest quarterly inflation report. Comments from the UK's Monetary Policy Committee seemed to suggest that the UK interest rate cycle was nearing its peak, which naturally led the market to conclude that the Bank of England was similarly unconcerned with inflationary risks.

So the market has taken its lead from the comments of two powerful central banks, and decided that inflationary pressures will ease as we move into 2005.

And if inflation is set to fall, then interest rates need not rise, at least not rapidly.

Thankfully, though, the European Central Bank offered a more realistic assessment of inflation in its August monthly bulletin, published yesterday.

Of the three major central banks, the ECB is arguably the most focused on inflation, since it is mandated to ensure 'price stability'.

Perhaps that's why the August bulletin adopted a hawkish and realistic tone.

While maintaining their long-held view that price stability remains achievable in the medium term, the authors of the August ECB bulletin do not ignore inflationary threats. They note that "oil prices continue to exert upward pressure on the general price level".

"Markets now expect oil prices to remain at high levels for a longer period than they did earlier this year. If this expectation were to materialise, annual inflation rates would most likely remain above target for the rest of this year and in the first few months of 2005," it said.

However, above target inflation will not immediately force an interest rate hike.

Annual inflation in the euro zone has exceeded the ECB's 2 per cent target for the past three years, and with the fragile state of the euro-zone economic recovery, the bank's Governing Council will want to hold rates at current low levels for as long as possible.

Yet the August bulletin contains some clear caveats, notably on the possible "second-round" effects of rising oil prices. In effect, the ECB are warning that they may have to reconsider the appropriateness of current interest rates if high oil prices become monetised in wage awards and rising prices.

If fuel costs remain high, trade unions across the euro zone will soon demand wage increases, which if granted, will inevitably lead to price inflation in the services sector. The ECB are effectively warning that such actions could force a pre-emptive interest rate hike.

And, finally, the ECB will no doubt be paying close attention to the euro zone's improving economic outlook. France and Germany have just recorded their fourth successive quarters of economic growth, and economists are actively revising euro-zone growth forecasts for the current year. It now seems possible that the 12-nation euro area will post 2 per cent GDP growth in 2004. There will be no justification for holding interest rates at current levels if the continent can achieve 2 per cent growth by year-end.

The financial markets currently expect interest rates to rise at a measured pace in the US, while in the UK rates are thought to be nearing the peak of this cycle.

As a result, the market is confident that euro-zone rates will not rise until mid-2005. I don't share this confidence, and if you find the ECB's latest assessment of the risks posed by inflation more realistic, then be on guard for rising rates within six to nine months.

Niall Dunne is financial markets economist at Ulster Bank