Hamish McRae: Testing times for Eurozone as ECB turns off the flow of cheap money

In Italy, rising rates will lead to howls of protest. It perceives it got a bad deal from the eurozone

Today, unless there is some astounding new information the rest of us don't have, the European Central Bank will increase its repo rate, the main interest rate, from 2.25 per cent to 2.5 per cent. This will follow a similar 0.25 per cent increase in December, which was the first change for two years, and the markets expect a further couple of increases through the rest of this year, to 3 per cent.

At one level this will be good news, for it shows that the president of the ECB, Jean-Claude Trichet, feels confident about the strength of the European recovery. After a dismal 2005 when the German economy grew only 0.9 per cent and the Italian economy did not grow at all, there is the prospect of things perking up through 2006. But the fact that European interest rates will at last become positive in real terms will put new pressures on some of the weaker countries in the eurozone, leading to problems in 2007 and beyond.

More of that in a moment; the good news first. There has been a sharp rise in economic confidence across the Continent and that points to significantly faster growth in output. You can see how the improvement in confidence is related to GDP growth in the first graph, which suggests that the eurozone could reach its potential growth rate of about 2 per cent in the coming months.

Much depends on rising employment. If the tone of the job markets improve, Europeans would have more confidence in the security of their income and might at last start to spend more.

The second graph shows the link here between industrial confidence, which is now at its highest level since February 2001, and hiring plans. Rising consumption is the key to sustained growth. This has been the missing link in Germany, where the export segment of the economy has been doing very well but where domestic consumption has been either flat or actually falling.

So the background has undoubtedly improved, albeit from a low base. That makes it credible to increase rates. But so too has the need to do so, for inflation has been nudging up too. Headline inflation is running at 2.4 per cent year on year. Core inflation, however, which excludes seasonal food and energy, is up only 1.3 per cent.

There is, as in the US and UK, a split between inflation in services and inflation in goods, with the latter much lower (third graph). Citigroup, which assembled these graphs, sees these as reasonably favourable but notes that the ECB will set these against the surprising strong lending and money-supply data in January.

These figures show that credit demand has increased sharply, with lending to households growing at an annual rate of nearly 10 per cent, the fastest since early 2000, and home loans rising at nearly 12 per cent a year. Not yet alarm-bells stuff, but fast enough for the ECB to want to lean against it.

So lean it will. The eurozone has had astonishingly low interest rates. At its simplest, most of the Continent has had negative short-term interest rates for the best part of four years. Inflation has in the main been above 2 per cent, the level of the ECB repo rate. Here in the UK interest rates have been higher and inflation lower.

The results, however, have been most uneven. In some parts of the eurozone, most notably Spain and Ireland, cheap money has supported property booms. Spain is building some 750,000 homes a year, far more than the UK has ever built in its history. That has helped propel Spain to the fastest growth on the large eurozone economies, but it is not sustainable. Spain now has a current account deficit equivalent to more than 7 per cent of GDP, the highest in the developed world. That is not sustainable either.

Germany, by contrast, has experienced falling property prices despite low interest rates. This raises the question as to how they might perform if there are indeed further increases after today.

Italy is different again. Whereas Germany has used the past five years to crunch down on its costs, Italy has failed to do so. While Germany has been rewarded with strong exports, Italy's exports have been very weak. That was one of the contributing factors for the country experiencing stagnation last year.

The key point here is that the period of very cheap money has caused different distortions in different parts of Europe. Now that this period is drawing towards a close, expect the different parts of the eurozone to respond in different ways.

In the case of Germany the issue is the impact, if any, on asset prices. I personally do not expect rates at even 3 per cent to be too negative, largely because long-term interest rates will remain very low and long-term rates are a more important determinant of asset prices than short.

But Germany is the largest economy in the eurozone and arguably has needed lower rates, not higher ones. So to an even greater degree than in the past the country will have to continue to live with the "wrong" rate.

In the case of Spain the issue is whether rising rates will prick the property bubble. Probably not. But something will have to, and the longer the adjustment is delayed the greater the danger of economic disruption.

In the case of Italy, rising rates will lead to howls of protest. Italy perceives that it got a bad deal from membership of the eurozone and any increase in interest rates will be most unpopular. Arguably Italy got a rather good deal for membership, in that the country cut the cost of servicing its national debt, but that is not the way this may play.

Elsewhere in the eurozone other countries will react in different ways.

Ireland will race on. It is in a similar position in some ways to Spain, though the underlying competitiveness of the economy is greater. In the Netherlands there will be concern, for it has been one of the worst-performing eurozone economies in the past couple of years. The Dutch (and indeed the Germans) may feel that they are being punished for the sins of the rest of the eurozone.

So there is a test coming up. The fact that the eurozone is making modest headway should be very welcome. It is conceivable, though unlikely, that it might grow as quickly as the UK this year.

On the other hand, the eurozone economy has not been stress-tested during a period of sustained increases in rates and we don't know how the various bits of it will perform.