'We're getting used to Dubya's foot-in-mouth approach, but when the US Treasury Secretary joins in, take notice'
It is always something of a two-edged sword when a central bank cuts interest rates. For that reason we should not be surprised that the initial reaction on Wall Street was negative to the Federal Reserve Bank's decision to make the eighth interest rate reduction so far this year. How far down can interest rates go? The 3 per cent lopped off so far this year is about as dramatic a reduction as we have seen. Yet business confidence in the US remains subdued, even if the consumer is steadfastly refusing to draw in horns.
The continuing confidence in the personal sector is partly buoyed by President George Bush's tax rebates dropping into mailboxes. Despite the dot.com collapse, most American consumers do not feel threatened by the retreat in the value of financial assets. Their sense of wellbeing is heightened by good state of housing in the US through the slowing of the economy. But even optimistic householders in the US must take account of one development: the mighty dollar has started to weaken.
A few weeks ago the dollar hit a 16-year high in currency markets. That made the euro look sick. Then events conspired to drive down the greenback. As is so often the case, politicians started the slide. First President Bush was equivocal in comments about whether the strong dollar policy remained in place. He told a leading European business newspaper in July that while a strong currency benefited the economy by attracting capital, it could also damage exporters. We are all beginning to get used to Dubya's foot-in-mouth approach in public, but when the US Treasury Secretary joins the debate, you have to take notice.
As it happens, what Paul O'Neill didn't say rather than what he did accelerated the dollar's decline. He didn't use the magic words "strong dollar" on American television a couple of weeks ago. And if he didn't say it, currency traders speculated, then it didn't exist. On went the slide of the dollar, and up went the euro, by rather more than the dollar had fallen against other currencies. Are their positions reversed?
Interest rates are often viewed as the dividend paid on a currency, so declining interest rates in the US do technically make the dollar less attractive to overseas investors. The euro, on the other hand, seems likely to enjoy higher interest rates for longer, given that the European Central Bank has been much more concerned with inflation than it has with kick-starting the German economy. Indeed, Wim Duisenberg said he saw no reason to join other central banks in lowering interest rates. But there are signs that Germany may be on the turn, while inflation has suddenly bumped down and is likely to decline further as a stronger euro cuts the cost of imports.
So the interest rate advantage the euro is believed to have will be eroded, but that does not necessarily mean that the decline in the dollar may stop. And if it does continue, as HSBC are suggesting in a lengthy note they sent to institutional investors recently called Dollar Doubts, this may, rather perversely, be good for the stockmarket and ultimately beneficial for the rest of the world.
The problem that America has is excess industrial capacity. The corporate sector has been retrenching rapidly and this, coupled with the implosion of technology businesses, has brought US economic growth down from 5 per cent to almost nothing. A weaker dollar will help the beleaguered manufacturing sector. Eventually, it will be good for corporate earnings. Because the US economy is so self-sufficient, and given also that commodity prices are weakening, a lower dollar should not induce any significant inflationary pressure in the short-term. Indeed, it may help restore confidence in financial markets.
True, American tourists may find they have less to spend when they travel over to Europe, but we may all end up being grateful for a couple of American heavyweights suggesting that, like any market or share, the dollar does not have to go on rising in a straight line indefinitely.
Brian Tora is chairman of the Gerrard Asset Allocation CommitteeReuse content