Dollar likely to remain dominant in 2002

With just over four weeks elapsed since the terrorist attack on the US on September 11th, financial market reaction has been quite muted. Predictably, many central banks rushed to cut official interest rates, while equity markets weakened in the face of increased economic uncertainty.

However, measured against the scale of the outrage committed against the US, the overall response of financial markets has been uncharacteristically restrained. Central bank governors and government officials have been heartened by the calmness of the financial markets, even after the commencement of military action by the US. Since the close of business on September 10th, the Dow Jones is down about 6 per cent. In Britain, the FTSE 100 has fallen by around 0.5 per cent.

On the interest-rate front, the US Federal Reserve has eased official interest rates by a cumulative 1 percentage point over the past month. Other central banks have cut their official rates by a smaller amount. Markets remain convinced that there are more official rate cuts on the way. As regards the currency markets, the US dollar has weakened slightly on a trade-weighted basis. The dollar fell against the Swiss franc and the Japanese yen but has shown little or no change against the euro.

The dollar has been helped by the intervention undertaken by the Bank of Japan, as the Japanese authorities have no interest in a stronger yen.

Euro-zone officials have been very quiet on the question of the euro but there is no doubt that they would not welcome a significant weakening of the dollar. An appreciation of the euro would damage European competitiveness and push the euro-zone economy closer to recession.

Capital flow data for the period prior to the attack on the US suggested that the balance was moving in favour of the euro. However, since September 11th, foreign exchange market activity has been relatively subdued.

Underlying business in the form of trade flows and mergers and acquisitions activity has slowed, thus providing little direction to currency markets. Nevertheless, the overall performance of the dollar over the past month must be regarded as resilient considering the increased risks to the US economy.

A technical recession in the US is now regarded as a certainty and the dollar is overvalued but the euro has failed to capitalise on this situation.

One part of the explanation for the continued strength of the dollar against the euro lies in the performance of the euro-zone economy. Data show that the pace of economic activity in the euro area has slackened considerably during 2001. The euro zone may avoid a technical recession but any expansion in real GDP will be modest.

The markets also remain concerned about the ECB's single mandate of controlling inflation, particularly in times of deepening economic gloom. There is a tendency to favour currencies where the central bank has been proactive in promoting economic growth.

With nine interest rate cuts so far this year, the markets believe that the Fed is the most supportive of economic recovery.

At the heart of the dollar's resilient performance against the euro is the belief that following a brief technical recession, lasting perhaps for three quarters from the third quarter of 2001, the US economy will rebound to its potential growth rate of 3 per cent or higher. A performance on this level, if achieved, would once again surpass that of the euro zone in the course of 2002.

There are indeed reasons to be confident that the US economy will recover in the second half of 2002. The reductions in US interest rates and the easing of US fiscal policy will encourage stronger activity by mid-2002.

The 4 percentage point reduction in the Fed funds rate since January has helped to sustain confidence in the US housing market. The personal tax cuts to date have resulted in a sharp rise in the US household savings ratio.

This should underpin a recovery in consumer spending in early 2002. The shake-out in fixed investment should also have come to an end by the middle of next year.

A further positive factor for the US economy is the high rate of productivity growth. This will be important for the Fed's continued relaxed interest rate strategy.

However, if the productivity growth rate stays relatively robust, the unemployment rates in the US will continue to rise over the next 12 months, possibly climbing above 6 per cent.

This is due to the expectation that the annual rate of economic growth will be less than 3 per cent until 2003.

Such a rise in the unemployment rate could unsettle confidence in the dollar in the short term, pushing the euro-dollar rate closer to $0.95 or higher. However, if the broader positive prognosis for the US economy proves correct, the dollar will reassert its dominant position in the course of next year.

John Beggs is chief economist with AIB Group Treasury