Less sunny US outlook would have global impact

If you want to know whether Irish interest rates will move higher and Irish equity markets will slide lower over the balance of the year, you might do well to start looking for answers on the other side of the Atlantic. In the past year, it was the buoyancy of the US economy that prevented an international recession, the resilience of Wall Street that underpinned global equity markets and the sequence of cuts by the US Federal Reserve last autumn that began the fall in interest rates worldwide.

As a result, it is worrying that the outlook for the world's "sunshine" economy has darkened in the past couple of months. While the risk of a complete US eclipse may seem remote at this point, it is an issue that policymakers and investors may grapple with in the near future. The result could be a difficult period for economies and markets around the globe.

The key question is whether the US economy can sustain current "hot" levels of activity without igniting higher inflation. Clearly, productivity increases have helped in this regard. However, tentative signs of emerging price pressures hint that temporary factors, such as last year's collapse in commodity prices and the glut of production capacity worldwide after the crisis in emerging markets, pushed inflation artificially low. The recent reversal of the commodity price downturn and early evidence of strengthening international activity suggest we may soon know whether the coincidence of "hot" activity and "cool" inflation in the US and elsewhere in recent years marks the arrival of a completely new set of economic rules or was simply an aberration.

If temporary factors played the key role, there is a considerable risk of higher US inflation unless there is a substantial and speedy slowdown in growth in the US. The problem for the Federal Reserve which has also unnerved financial markets lately, is that it might require quite aggressive policy action to deliver markedly slower growth. The manner in which the US economy weathered last year's global storms and the dismissive fashion in which Wall Street shrugged aside a quarter per cent increase in official rates back in June suggest altogether stronger medicine could be needed.

This is because a succession of years of strong growth in incomes and capital values lend significant support to consumer and business spending. That experience and the associated build-up in wealth may insulate households and businesses from a modest tightening by the Fed. Of course, these same factors also make the economy more susceptible to a build-up of price and wage pressures.

If the US economic climate points clearly in the direction of higher interest rates, limited evidence of poorer inflation and a range of other factors may cause the Fed to tread cautiously. One complication is next year's presidential and congressional elections. A Federal Reserve mindful of a sometimes uneasy relationship with Capitol Hill needs to be seen to act to restrain inflation and not to damage an economic upturn that only recently began to bring clear benefits right across US society. While the Fed will strive to distance itself from accusations of political interference, the election countdown could affect the timing of its actions.

That timing may also be influenced by concerns about the financial market implications of the Y2K problem. Yet another concern is that a still fragile upturn in the global economy and, particularly, in emerging markets could be extinguished if the Fed hikes rates aggressively. Some at the Fed also fear the possibility of a sharp downturn in equity markets.

Completing a daunting set of considerations for the Fed and market investors is the risk of a substantial fall in the dollar. In recent years currency markets have supported the dollar because of superior US economic performance and complete confidence in the Fed. That allowed US households run down savings and permitted the economy to finance a yawning trade gap without any risk premium. In addition, the boost to the dollar from overseas investors' confidence in the US acted as an additional brake on inflation. If confidence is lost in coming months, this virtuous circle could transform into a vicious cycle.

The resultant weakening of the dollar would constitute another ingredient in higher US inflation and the trade deficit and inadequate savings would become significant market concerns.

These considerations underline the delicate balancing act that must be at the heart of Fed decision-making and investor position-taking in the next few months. While there may be grounds for the Fed to tread warily, investors may be quicker to vote with their feet, particularly if upcoming data point towards higher inflation.

Nervousness about the extent and timing of interest rate increases in the US could represent a difficult backdrop for equity markets right around the globe. Further pressure on US interest rate markets would also aggravate an upward trend in longer-term Europe rates. That could prompt a rise in "fixed" rate products on the Irish market. Paradoxically, it could also delay the eventual rise in variable interest rates by dampening the likely upturn in the European economy and pushing back the first hike by the European Central Bank.

Austin Hughes is senior economist at Irish Intercontinental Bank