Bouncing the dead cat or stimulating a US recovery?

The dead-cat bouncers and the optimists have both used the Fed rate cut tosupport their arguments, writes Cliff Taylor, Economics Editor

The earliest known reference to the phrase "dead-cat bounce" was a quote by a US investment banker in 1986. It referred, the banker explained, to stocks or commodities that had fallen sharply and then rallied briefly, but for which the outlook was still poor.

"If you threw a dead cat off a 50-storey building, it might bounce when it hit the sidewalk," he said. "But don't confuse that bounce with renewed life. It is still a dead cat."

Economic opinion is divided at the moment between the "dead-cat bouncers", who believe that the recent rise in equity markets is irrational and unsustainable on the basis of a poor economic outlook, and the revivalists, who detect the first signs of an international economic recovery. Which school is correct has enormous relevance for the State.

The last week or so has given some encouragement to the revivalists. A number of US indicators looked better and even the German Ifo index of business confidence lifted a little. Then, on Wednesday, the US Federal Reserve cut interest rates by 0.25 of a percentage point to 1 per cent, their lowest level in 45 years.

Both schools found support in the statement that accompanied the Fed cut. The doomsters focused on its comments that a sustainable recovery was not yet under way and a lapse into deflation, however unlikely, was a greater risk than a pick-up of inflation. Meanwhile, the optimists noted the Fed's view that spending is firming, financial conditions are improving and labour and product markets may be stabilising.

Yesterday two pieces of data did little to clear the picture. A fall in US jobless (unemployment) claims to a three-month low suggests that the Fed was correct that the labour market may be stabilising. But an anaemic GDP growth rate of 1.4 per cent in the first quarter suggests it was also right when it said that sustainable recovery was not under way.

Nobody expects that growth in the second quarter was much better, with investment and confidence damaged by the Iraq war and its immediate aftermath.

The uncertainty now is whether the second half of this year will see the first signals of the long-awaited pick-up, or whether the hangover from the boom will last into 2004. Will the US economy respond to the significant stimulus from low interest rates and tax reductions - and possibly further falls in the US dollar - or will the high level of business indebtedness and the poor state of US export markets continue to hold back the investment recovery, which is required to lead any upturn?

The US corporate sector will be the key in the months ahead. The optimistic view is that the recovery in consumer confidence and spending will knock on to a pick-up in business confidence and investment levels, returning the US economy to its virtuous growth circle. The danger is that the stop-start pattern continues, with indebted businesses nervous of adding further pressure to their balance sheet.

At a macro level, the constraint facing the US economy is best expressed in the current account balance of payments deficit. This reflects a deficit - currently amounting to some 5 per cent of US GDP - in the day-to-day dealings of the US with the rest of the world.

Many analysts believe the deficit points to a weaker dollar for a prolonged period. A weak dollar would help to "rebalance" the US economy by boosting exports but restraining domestic demand by pushing up import prices.

More pessimistic analysts believe the US is heading for a couple of years of below-par growth while this deficit is being worked out of the system.

A further weakening of the dollar would turn the screw further on our economy by damaging exporters. Trade figures for the first four months of the year, published yesterday, suggest that export conditions remain difficult for Irish industry, although it is unclear how much of the 20 per cent fall in exports in the first four months is due to lower export volumes and how much to falling prices that exporters are getting on world markets.

The importance for Ireland of what happens in the US over the next few months cannot be over-emphasised. A US pick-up in the second half of the year, followed by some recovery in the euro zone in 2004, would mean that Irish growth could recover to reasonable levels of 3 per cent plus next year.

However, if the US does not pick up, there is unlikely to be any stimulus to the euro-zone economy and Irish growth could remain at 2 per cent or less. This would leave an unpleasant outlook of rising unemployment and pressure on the public finances.

Irish policymakers will hope that the Fed's action this week will help to create a real "bounce" in US activity in the second half of this year. However, we are not out of the woods - even the Fed is not sure the recovery has arrived.