Sterling pothole on road to monetary union

THE Government and the Central Bank are facing their first big test on the road to monetary union.

The strength of sterling is pulling the pound up to the top of the ERM band. If the Irish currency rises any further, then the Central Bank will have to sell the currency on the market to hold it down and quite possibly reduce interest rates.

There could be no clearer signal of the impact that monetary union is having on domestic policy making, than that it is leading to speculation of a reduction in interest rates. With the economy growing so strongly and credit growth buoyant, an increase in interest rates might appear more logical.

But it we are serious about qualifying for EMU, then going through the top of the ERM band is simply not an option, as it would breach - one of the Maastricht rules. And increasing interest rates to try to cool the economy would only send the currency higher by making Irish pound investments more lucrative. So it is quite possible that the Central Bank may have to move to cut rates in coming weeks, unless a reversal in sterling's fortunes saves the day.

Whether lower interest rates would have much of an impact on the currency's value is another matter, of course. Economic opinion is divided on whether it is the gap between Irish interest rates and those elsewhere in Europe which is attracting money into pound investments or whether it is the relative strength of the Irish economy.

And to compound the Central Banks problems, tower interest rates could conceivably add further fuel to the economy's tank and lead to a pickup in inflation - a low inflation rate is another criteria for qualification for monetary union.

A focus on the pound is not what the Central Bank would want at the moment. Already the initial sparring is taking place over who will participate in the first phase of monetary union witness the current tensions between Germany and Italy.

And some high placed German officials and central bankers still doubt whether the pound should enter monetary union without sterling. Still, the Government here is determined that we will fully meet the Maastricht criteria, which would mean we cannot be excluded when the final decision is made. There is still considerable uncertainty about the likely size of the group which will move forward to monetary union, and even increasing fears that Germany itself could struggle to meet the budget deficit rule because of rising unemployment.

The position should become clearer later this year. But for the moment Irish policy is to remain on course, meet the criteria and thus ensure there can be no questioning of Irish membership. And this means that currency and interest rate policy will be driven by the need to meet the Maastricht rules, rather than on the basis of domestic economic performance.