Wait-and-see best for Europe

DIVISIONS are appearing in the European Central Bank over whether Euroland should be leading the world towards higher interest rates. In the past three weeks, its president, Wim Duisenberg, has toughened up his rhetoric about the threat from stubborn inflation, talking for example about the 'poison' of wage-price spirals. This has created expectations that the central bank will tighten the credit reins a notch at its next Council meeting on 6 June.

But Yves Mersch, head of Luxembourg's central bank, appears to be leading internal opposition to such a pre-emptive strike. Other Council members are dubious too, said Julian Callow, European economist at Credit Suisse First Boston.

Luxembourg does not carry much weight in the ECB. But Mersch might be able to count on tacit support from Germany. Given the laboured revival of its economy, Gerhard Schroeder, the only Chancellor in history to secure legal protection against Press reports that he dyes his hair, will not be keen to see interest rates rising ahead of September's General Election.

The ECB's decision is also being made more difficult by French President Jacques Chirac. He has launched what amounts to a frontal assault on the European Union's fiscal strait-jacket, the Stability and Growth Pact, indicating he wants to delay from 2004 to 2007 the date when France achieves a balanced budget.

This will have left some in the ECB's Frankfurt tower spitting blood. The Bank has stressed in the past, and Duisenberg reinforced the point before the European Parliament on Tuesday, that the restraints of the pact, flawed though they may be in some ways, are still an essential part of the eurozone's stability-focused economic policy infrastructure.

As the world economy recovers, it is inevitable that central banks will eventually increase interest rates from the emergency levels of last autumn. Then, amid fears the terrorist attacks on the US on 11 September might trigger a global collapse in consumer and business confidence, the ECB and the Bank of England followed Washington's lead and chopped. By 11 December, the US Federal Reserve had cut to 1.75%, against the ECB's 3.25% and 4% at the Bank of England.

But here is the puzzle. Unlike the ECB - and the BoE - the Fed is showing no signs of upping rates from 40-year lows now the emergency is past, even though the initial signs of economic recovery are clearest in the US. First-quarter gross domestic product expanded 5.8% and some private economists are expecting a growth rate of 4% in the second quarter.

In Euroland, by contrast, hard evidence on the economy is only just emerging. It will not be until next Thursday that a eurozone first quarter growth estimate will be released. John Llewellyn, global economist for Lehman Brothers, said a 'homegrown' economic upturn is taking hold. But it may not yet be particularly vigorous as German and French GDP figures today and tomorrow will show.

So why is the Fed reluctant to tighten monetary policy even though America seems to have escaped from recession, while the ECB appears to be chomping at the bit? Part of the answer is that Fed chairman Alan Greenspan fears US expansion could run out of steam. Americans continued their shopping spree through the slowdown, which means consumers will not be able to kick-start the recovery in the usual manner.

In addition, when setting rates, the Fed has to pay equal attention to inflation and growth. So with inflation still rising at an annual rate of only 1.6% in April, it can wait and see, even though America's stock market bubble has shifted to the housing market.

For the ECB however, curbing inflation is its top priority and sustaining growth comes second. Inflation in Euroland has been running above 2% for almost two years now. This is causing red faces at the top of its Frankfurt tower block where officials worry about the damage this failure to meet its self-inflicted inflation goal may be doing to its credibility.

Euroland's slowdown has also been free of the excesses which have characterised America's boom and bust, so a slight tightening of monetary policy is less likely to cause trouble. But with Europe's economic revival still patchy, a rate rise on 6 June - three days before French parliamentary elections - might trigger another round of subtle ECB-bashing by some continental politicians.

America's leaders would waste no time joining in, even if they confined their criticism to the privacy of the meeting room of leaders of the Group of Seven. As the imposition of protectionist measures to help the US steel industry was partly designed to demonstrate, Washington has no intention of allowing America to become the world's consumer of last resort again in this economic cycle.

It wants to see Europe growing as quickly as possible to help power the global recovery, not pre-emptively raising interest rates. So it is not just in Frankfurt that the Euroland economic policy debate is hotting up.

With political sensitivities so high and the dollar under sustained pressure now, even against Japan's yen, the ECB may feel that Luxembourg's Yves Mersch is right, and, like the Fed, decide its best policy is to wait and see a while longer before tightening credit.