EIU forecasts 100 bp interest rate cut by 2006

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In its first update since the Cyprus pound entered the Exchange Rate Mechanism (ERM2) on May 2, the Economist Intelligence Unit has forecast a 100 basis-point cut in interest rates by the end of 2006, while the government is expected to meet its budget deficit target this year.

In its May 2005 Cyprus Country Report update, the EIU forecasts a cut of 50 basis points in 2005 and another 50 basis points in 2006.

At present (and perhaps only until Friday) the minimum bid rate on main refinancing operations is 4.25% in Cyprus, compared with 2.00% in the eurozone.

The EIU forecast is made on the assumption that the European Central Bank keeps interest rates unchanged in 2005 but raises them moderately in 2006.

The forecast implies, therefore, that the spread of official Cyprus rates over Central Bank rates will fall from 225 now to perhaps 100 basis points in 2006.

Jan Friederich, Senior West Europe Analyst at the Economist Intelligence Unit, told the Financial Mirror that most of the convergence of interest rates happens in the last period running up to the adoption of the euro.

Euro-area membership in 2008 is seen as “more practical” than mid-2007, the earliest date when Cyprus could adopt the euro.

Confidence in the pound

The Cyprus pound is forecast to stay rock solid at 0.584 per euro–slightly above its central rate in the eurozone.

The decision to keep the parity rate the same as before “ implies a vote of confidence in the current central parity, and consequently a devaluation of the Cyprus pound has now become even less likely,” says the report.

Real GDP growth is expected to accelerate in 2005 to 4%, before slowing to 3.5% in 2006, but the current-account deficit will shrink as a result of improving tourism revenue and slowing domestic demand.

Big drop in oil prices

The report, which also contains the key assumptions on the global economy, forecasts a big drop in oil prices from an average USD 46/barrel for Brent crude in 2005 to USD 40 in 2006.

The good news for Cypriot consumers is that this will be even cheaper in euro terms, as the dollar is forecast to slip to an average 1.40 per euro in 2006.