The Fed and the euro

The Fed has raised interest rates sharply in the US

By business reporter Jonty Bloom

This week the Federal Reserve, the Central Bank of the the USA, raised interest rates by half of one percent.

This is the first time that it has increased rates by so much since 1995. It follows 5 increases in interest rates by a 1/4 of one percent since June last year.

Apparently the expectation in the markets is that the Fed may well increase interest rates again next month and even again in August.

That's a clear sign that the Federal Reserve isn't just worried that the inflation rate in the USA is rising too quickly. It is making it fairly obvious that it is worried about the whole economy.

These increases are designed to slow down what is being seen as an unsustainable economic boom.

Bad news for the euro?

In the short term all of this is bad news for the euro.

Higher interest rates in the States make holding on to the dollar a more attractive proposition.

In the short term that may well force up the value of the dollar and push the euro lower as dealers sell the European single currency in favour of the US currency.

But in the longer term it should be better news. The Federal Reserve seems determined to slow down the US economy.

One of the reasons for the euro's weakness is the fact that compared to the fantastic growth record of America, Europe looks like a weakling.

European weakling

Or at least most of it does. Places like Ireland and the Netherlands have enjoyed booms that compare very well with the one in the USA.

But their problem is that they can no longer increase their own interest rates to slow down the economy, as the Federal Reserve is doing in America.

The European Central Bank looks at the whole of Euroland when fixing rates and sees few signs that the whole region is overheating.

That means that Ireland and the Netherlands have to find another way of slowing down the economy, and that means either raising taxes or cutting spending, or even both.

The Dutch central bank warned on Wednesday that the country risks overheating if the Government spends more.

Instead the bank wants the government to spend any windfalls on bringing down debt.

The Dutch government, however, is committed to tax reforms next year, auctioning telephone licences and spending more on health and education. Ireland is in a fairly similar situation

. Both countries need to bite the bullet, but it is far more difficult for politicians to do that than it is for central bankers.

After all central bankers don't need to win elections.