On numerous occasions over the past couple of years, currency analysts have risked sticking their heads above the parapet and proclaiming that the euro had at last turned the corner and left the worst of its problems behind. Such pronouncements proved hopelessly premature and as recently as October the euro hit fresh lows against the dollar and yen. However, we have seen some compelling evidence over the past couple of weeks that the corner may have been turned and, for lovers of the currency, there is at last some light on the horizon. From the point of view of the Irish economy, particularly in the aftermath of this week's expansionary and inflationary Budget, a stronger euro would represent good news in the fight against inflation. However, for exporters whose cost base may have been allowed to increase against the background of a weak currency cushion, an aggressively strong euro recovery would not be good news.
There has been a fundamental change over the past couple of weeks, which would lead one to believe that the euro has, at last, turned the corner. In 1999, it was naively believed that a euro zone economic recovery would be sufficient to change the ailing fortunes of the currency. A relatively strong economic recovery in the zone did materialise but the much more impressive growth performance of the US economy ensured that capital continued to flow into the US and propel the dollar higher. Eventually, it became clear that, in addition to stronger European growth, some sort of US shock would also be necessary to take the shine off the lovable dollar. In some senses, we have seen such a shock emanate from the US in recent weeks. Over the past three months, the markets have moved from anticipating whether or not the Federal Reserve would have to increase interest rates again to check the economy, to a situation where many market participants are contemplating notions such as hard landing and recession. Mr Alan Greenspan, the Federal Reserve chairman, indicated on Tuesday that he shares these fears. The technology-laden Nasdaq has been the main casualty of this change in sentiment but the long love affair of investors with the dollar has also come under close scrutiny.
In the context of the US economy, terms such as recession and hard landing look a tad over the top. There has, undoubtedly, been a sharp slowdown in US activity over the past quarter, and business and consumer confidence has started to take a battering. Higher interest rates, a very negative equity wealth effect, higher corporate lending rates and political uncertainty have combined to undermine sentiment and activity. However, it is premature to talk about recession, particularly given this week's comments from Mr Greenspan suggesting that he would be prepared to come to the rescue again and cut US interest rates, if necessary, to sustain the economic growth. But at the end of the day, whether it is a hard or soft landing for the economy, growth will slow down, interest rates will fall and capital flows into the US will decelerate initially and, eventually, may even go into reverse.
This looks like a reasonable background for the euro and, indeed, it has bounced more than 8 per cent off its lows in recent days. However, lest one gets carried away, it is important to bear in mind that a slower US economy could undermine the relatively modest euro zone economic recovery and dampen market ardour towards the euro.
We have seen many false dawns with the euro over the past couple of years but, at this stage, cautious optimism would appear to be in order.
From Ireland's point of view, a stronger euro should be good news on the inflation front, although one should not get carried away. I believe that excessive demand in the economy is the key driver of Ireland's current inflation problem - and I am not just referring to inflation as measured by the Consumer Price Index. This week's massive and ill-conceived fiscal injection into the economy will add further fuel to demand and ensure that inflation, broadly defined, will remain a feature of the economy in 2001. Suffice it to say that the problem would be even worse if the euro remained as weak as it has been. For Irish exporters, a stronger euro would undermine competitiveness in an environment where competitiveness is already being damaged by rising labour and other input costs. For an economy whose cost base is rising so significantly, a sharp euro appreciation would not be helpful. Then again, a sharp appreciation is probably not on the cards, just a gentle bumpy ascent.
Jim Power is director of investment strategy at Friends First Asset Management.
