If Greenspan gets it wrong, Europe will feel the pinch

If the dollar moves even halfway back towards its trough, the entire continental economy would be in difficulty
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This week all eyes in the world of finance will be on Washington, where today the Federal Reserve Open Market Committee has its monthly meeting on interest rates. The immediate question it faces is whether to sanction another rise in US rates, for there has been considerable concern about the rapid growth of the US economy during the first quarter of the year.

The commentators are divided as to which way the Fed will jump, but the balance of opinion is that it will agree to a quarter per cent rise in rates. The argument for that is that though there is as yet little sign of renewed inflation, there is considerable pressure in the economy, particularly in the labour market: a falling unemployment rate and a rise in overtime hours. The low inflation, it is argued, is the result of past economic conditions and in particular the way in which rising demand for labour has coincided with rising job insecurity. The result has been that, so far, demand for labour has not resulted in rising wage pressures. But obviously this will eventually happen.

The argument against a rise this week is that the rapid growth of the first quarter seems to have eased a bit now. Given the low inflation, a rise in rates may not be needed - or in any case can wait until there is evidence that it is.

Now, no one outside the Fed has any idea which way it will jump, and Alan Greenspan has been careful in recent weeks to give his usual contradictory signals. In any case while it may be of great interest to aficionados of monetary policy, whether US interest rates move by a quarter per cent this month, or next, or the month after, is not really going to get people dancing in the streets.

That said, however, US monetary policy over the next few months does have a global significance. It looks as though the dollar may have reached a turning point. Having climbed steadily since the spring of 1995, it seems to have turned down. If that is right, the pace at which the Fed increases interest rates will have an important impact on the profile of the coming dollar decline.

We do not, of course, know that the dollar has indeed turned. But the market seems to have taken to heart last month's Group of Seven statement that the currency ought to stabilise, and the most recent decline against the yen has broken the upward trend line. For people who follow charts, this is apparently significant: while no one is suggesting that the dollar/yen rate might go back to the Y80 region it hit two years ago, a rate in the Y105-110 range is now considered perfectly plausible.

Some more conservative forecasts for the dollar, against both the mark and the yen, are shown in the chart. Deutsche Morgan Grenfell, which produced them, reckons it is unlikely that the dollar will weaken substantially in the next few months, for a sustained decline would add to inflationary pressures in the US and so would be met by a policy tightening. In fact in the short-run it expects the dollar to recover a bit. But it does expect some modest fall next year, as the chart shows.

If that is what happens, everything is fine. Or rather things are fine in the sense that currency rates will not damage the world economy. Stability between the three main currencies is particularly important at the moment, for were the dollar to fall too fast, that would undermine the economic recoveries of Japan and Germany, both of which remain fragile. The dollar at present levels may still seem cheap in terms of its purchasing power parity - on those grounds it could rise another 10-15 per cent without looking overvalued. But a cheapish dollar is appropriate because the US still has a significant structural current account deficit. If you believe that there ever can be a "right" rate for the dollar, it is probably just about there now.

Looking ahead, though, there are risks. One of these is that the dollar will weaken too quickly. This would be likely to happen were the Fed seen as being tardy in the pace at which it increased interest rates. The whole Continental recovery, insofar as it exists, is driven by exports: domestic demand in France, Germany and Italy is flat, as the retail sales for those three countries show. In all three countries the year-on-year change in retail sales is minus 3-4 per cent, a much bigger decline than at any stage here in the UK during the last recession. At the present exchange rates, continental European exports are competitive on world markets. If the dollar moves even halfway back towards its trough of two years ago, they would be back in some difficulty. Since there is nothing else to boost demand, the entire continental economy would be in difficulty too.

So if, following today's meeting, there is no change in US rates, watch the foreign exchanges to see how the dollar reacts. Serious weakness of the dollar in the coming months is bad news for Europe.

The opposite danger also exists. The turn in the dollar has been largely the result of words: statements by the G7 and the Japanese authorities, maybe backed from time to time by central bank intervention in the markets. Were the markets to decide that this was a bit of a mistake - that, for example, a mark due to be converted into a weak euro is not a currency to hold - then we could be back to an overvalued dollar next year. Were the Fed to continue pushing US interest rates upwards through this year, the upward pressure would be all the greater. This would help Europe's recovery and further fuel Japan's, but in the long term, damage to US competitiveness carries dangers. At some stage the US boom will end. Can it achieved a soft landing, or will that be a hard one?

The central point here is there is always the danger that the Fed will make a mistake. Dr Greenspan has achieved mythical status for managing the long, non-inflationary US expansion. That is fine, but it is also alarming for the success is not entirely his (or the Fed's) work. There is considerable complacency in financial markets at the moment. But we are moving into a period of rising world interest rates - always a difficult part of the cycle. Among the brokers, UBS is worried about this complacency, and I think it is right to be.