Investor: An insider's guide to the market

Rising oil prices and rising interest rates continue to dominate the financial news this summer. The recent spike in the oil price, coming on top of the steady rise over the previous 12 months, has sparked worries over inflation and economic growth.

Since the beginning of the year, oil prices have risen by approximately one-third and by close to one-quarter over the past six weeks alone. Not surprisingly, the financial media has latched on to the potentially negative impact on the global economy if oil prices continue to rise. Some commentators are now beginning to talk of an oil price going as high as $50 per barrel.

In contrast, the reaction among monetary authorities and across the financial markets has been relatively calm. It is true that equity and bond markets have been weak for some months. However, it is difficult to disentangle what factors are actually causing this weakness.

The higher oil price is only partly to blame as many analysts have fundamental concerns about the durability and sustainability of the current global upturn. At the core of these concerns are the risks posed by the cumulative build-up of consumer debt in many countries.

Monetary authorities have also been sanguine regarding the oil price spike. Over the past 12 months the UK and Europe have been cushioned somewhat by the strong UK pound and the strong euro, since oil is traded in US dollars. Another important point that often gets lost in the media hype is that in real terms the oil price is still less than half the high levels reached in the late 1970s and early 1980s.

Furthermore, with the industrialised countries becoming much more service-oriented over the past 20 years, the relative importance of oil to the advanced economies has diminished. The price of oil is important but it is only one of a variety of factors that central bankers take into account when setting monetary policy.

At its recent meeting, the European Central Bank (ECB) decided to leave short-term interest rates at 2 per cent. Although the higher oil price is now likely to push euro-zone inflation to just above the ECB's 2 per cent target, most analysts expect the bank to defer an interest rate increase until the euro-zone economic recovery gains more traction.

This means that it could be later this year or early 2005 before the ECB begins the process of raising interest rates. Developments in the oil markets will influence the decision-making process, but the health of the overall euro-zone economy will be more influential.

Irish interest rates are of course now determined in Europe. Nevertheless, it is instructive to look at developments across the Irish Sea. Last week the Bank of England announced its fifth successive quarter-point rise in interest rates to bring its main base rate to 4.75 per cent. In terms of monetary tightening the UK is well ahead of central banks in both the US and Continental Europe.

The UK economy has been performing far better than the large European economies such as Germany, France and Italy and the Bank of England has decided to move early to contain any future inflationary pressures.

The advanced stage of the British economic recovery compared with that of continental Europe justifies much higher sterling interest rates.

Comparisons with the US highlight the difference in approach being adopted by the US Federal Reserve and the Bank of England. US interest rates have begun to rise but are still lower than European rates and well below UK rates. This is despite the US economy having enjoyed strong economic growth over the past 12 months. The pace of this growth did slow somewhat in the second quarter but most economists are still predicting a good second-half economic performance.

With inflation still well-behaved it seems that the Fed is willing to risk stoking future inflationary pressures to secure strong economic growth. US interest rates are certain to rise, but the increases seem set to be spread over a prolonged period.

With interest rates on the rise across the globe, the big question is how high rates will ultimately go. Some Irish analysts are predicting a rise in euro-zone short-term interest rates of between 1.5 per cent and 2 per cent over the next 18 months.

Some clues can be gleaned regarding the ultimate rise in Irish interest rates from the monetary policy committee's (MPC) statement accompanying the most recent rise in UK rates. To many economists surprise, the tone of the statement suggested that the MPC was taking the view that the cumulative impact of its rate rises so far was beginning to have the desirable impact on housing and consumer spending.

The MPC said although the housing market remained buoyant there were signs that it had started to ease. On consumer spending, the MPC suggested that growth in consumption might now be moderating.

Futures markets quickly reacted to this statement with the curve moving lower and it now implies that UK interest rates will peak at 5.5 per cent sometime in late 2005 or early 2006. If this proves to be the case it would mean that a rise of two percentage points was sufficient in the current UK interest rate cycle.

Therefore, the UK experience is now beginning to lend support to the view that euro interest rates will rise by no more than two percentage points over the next one to two years.