US uncertainty was crucial factor in recovery of the euro

Having come perilously close to breaching the magical parity barrier against the dollar, the euro has rebounded strongly in recent weeks and has suddenly become an object of some desire. This change in fortune has been helped to some extent by tentative signs of economic recovery in Germany. However, those signs would not have been enough on their own to rescue the ailing euro, something more was needed.

That something is a growing belief that the longest US expansion for 40 years may be starting to show the first signs of running out of steam. This reality has suddenly turned dollar bulls into bears and the whole tone of global economic research has changed quite dramatically in a relatively short space of time, proving how fickle the markets are and how imprecise the "art" of exchange rate forecasting really is.

This fickleness is probably indicative of the way in which economic research globally has been "dumbed down" in recent years as economists are increasingly pushed into a marketing role, at the cost of decent economic research.

The big question now is the extent to which the US slowdown story is soundly based or whether it is just the herd mentality of commentators and traders coming to the fore again. If the slowdown story is proved erroneous, the new dollar bears will be forced into another inglorious retreat and we might just see a rebirth of the "parity" merchants.

The jury is still out on that particular issue as the evidence coming through on the economy is still pretty mixed, but caution is advised against jumping to the conclusion that the slowdown story is correct. There is ample evidence to suggest that the economy still has lots of pep in its step.

The main evidence supporting the slower growth story was provided by the GDP report for the second quarter. Annualised growth fell to 2.3 per cent, from 4.3 per cent in the first three months of the year, and 6 per cent late last year. However, the primary reason for the pronounced fall in growth in the second quarter was a sharp rundown in inventories in the face of ongoing solid domestic demand. The likelihood is that in the second half of the year, companies will start to build up their inventories again, particularly ahead of Y2K. This is likely to give a solid boost to growth and complement ongoing strong consumer spending.

The consumer has been the main driver of the economy in the second half of the current expansion, driven by strong job creation and an equity market that has been pushed ahead by "animal spirits". The most recent employment report for July confirmed that the labour market is still moving strongly, but the equity market has become distinctly nervous.

This equity market nervousness is a result of an investment community that is quite uncertain about the true economic health of the US. The overriding perception is that growth is really slowing, and that we are now seeing a late cycle upturn in wage and price pressures. The fear is that this combination of events will result in the Federal Reserve having to tighten interest rates in an environment where growth is decelerating.

While the slower growth story is still far from convincing, the inflation story is becoming somewhat more compelling. Over the past month we have seen strong growth in average earnings and overall employment costs, and most worrisome from the point of view of the chairman of the Federal Reserve, Alan Greenspan, productivity growth has slowed significantly.

In his last testimony to Congress, Mr Greenspan mentioned the word productivity more than 40 times. It is clearly an issue that interests him. His belief is that with unemployment so low and with the economy effectively at full employment, just like Ireland, output per worker would have to continue to grow very strongly to prevent an outbreak of wage pressures. The latest weak productivity numbers suggest that this is not happening, so Mr Greenspan now has little option other than to increase interest rates. He is likely to do this on August 24th, by 0.25 per cent and probably by a similar margin in October. This would fully reverse the rate easing implemented in the midst of serious global uncertainty last year, and would be fully justified at this juncture.

This is likely to remain a nervous background for US equity and bond markets and the combination of more volatile equities and higher short and long-term interest rates should eventually bring the economy down from its highs. Mr Greenspan needs slower growth because as driver of the global economy over the past couple of years, the US is now left with the legacy of a very large trade deficit, which could eventually bring the dollar crashing down. It is now up to Europe to take the growth mantle from the US and rebalance global economic activity. Against this background it would be utterly irresponsible of the European Central Bank to tighten its interest rates at the first sign of a pickup in economic activity. It is now up to European central bankers to show where their priorities really lie.

Jim Power is chief economist at Bank of Ireland Treasury