ECONOMICS: Even on an optimistic reading of US economic data, the short-term outlookfor the economy is for growth in real GDP below its non-inflationary growthpotential. The dollar has recovered some ground in recent weeks against the major currencies, but the US currency remains overvalued despite itsfall since the start of the second quarter of 2002... Several factors are providing short-term support to the currency.

The outlook for the global economy has taken a turn for the worse in recent weeks. The gloomy outlook for US equities has been reinforced by a deterioration in the prospects for the US economy. The OECD has reported that its composite leading indicator suffered its first decline since October 2001, pointing to the risks of a double-dip downturn in global activity.

Talk of official rate increases by the major central banks have turned to speculation that official rates may have to be cut in order to support the flagging international economic recovery. The markets no longer believe that official rates will rise this year and expectations about the extent of such increases in 2003 have been scaled back.

On the currency front, the decline in the US dollar has been arrested, at least temporarily, as investors come to realise that many other economies are performing just as poorly as that of the US.

In his testimony to the US Congress on July 17th, the Federal Reserve chairman, Mr Alan Greenspan, was relatively upbeat about the short-term prospects for the US economy and the underlying economic fundamentals. He did, however, caution about the serious risks to the efficiency of the economic system from the breakdown in trust in corporate governance and accounting practices.

In the absence of a strong US economic performance to occupy investors' minds, this breakdown in corporate accountability contributed to the sharp fall in equity markets and in the dollar.

Despite these problems, Mr Greenspan outlined to Congress that the Fed believed the US economy would grow by 3.5-3.75 per cent in the year to the fourth quarter of 2002 and by 3.5-4 per cent over the following 12-month period. The forecasts for end-2002 are too optimistic at this stage and the end-2003 forecasts are challenging.

When the Fed's interest rate setting policy committee, the Federal Open Market Committee (FOMC), last met on June 25th and 26th, official interest rates were left unchanged at 1.75 per cent. The committee also maintained a neutral stance as between the risks to inflation and the risks to sustainable economic growth.

Since then, however, economic data have been disappointing and the outlook has deteriorated.

It has now emerged that the US economy suffered a deeper and longer-than-expected recession in 2001, with real GDP declining in each of the first three quarters of the year. Since then, the recovery has been unspectacular, notwithstanding the annualised growth of 5 per cent in the first quarter of 2002, which was due largely to the positive contribution from changes in inventories. The advance estimate of growth in the second quarter was significantly lower at 1.1 per cent on an annualised basis.

The indications are that growth will be very moderate in the third and fourth quarters of 2002. The recently published non-farm payrolls and the Institute of Supply Management surveys point to weak employment growth and slowing output growth in manufacturing and services.

In the meantime, equity markets have been weak, raising fears that US consumer confidence will tumble, causing a greater rise in personal savings and a downturn in personal spending.

There does not appear to be any immediate worry on this score as the latest data show that real consumer spending rose by 0.4 per cent in June over May. The strength of the housing market also offers support to US consumers.

Looking to next week's FOMC meeting, therefore, there is no urgent need for a rate cut. However, in the light of the recent softening of activity, the Fed could move to an easing bias, thereby signalling its readiness to support the economy in the event of further losses on Wall Street.

Even on an optimistic reading of the US economic data, the short-term outlook for the US economy is for growth in real GDP below its non-inflationary growth potential. A recent report by the International Monetary Fund on the US economy calculated this growth potential at about 3.25-3.5 per cent. The economy will struggle to attain and sustain this rate over the remainder of 2002.

Under these circumstances, the markets are likely to continue to speculate about the prospects of further easing by the Fed. The Fed will monitor developments very closely in the months ahead, conscious of the need to avert a deflationary climate in the US economy. However, the economic fundamentals should support a return to growth close to the economy's potential in 2003, accompanied by moderate inflation.

The dollar has recovered some ground in recent weeks against the major currencies, but the US currency remains overvalued despite its fall since the start of the second quarter of 2002. On a trade-weighted basis, the dollar fell by 6 per cent from its high at the end of January to its low in mid-July. Since then, however, it has recovered by 2.5 per cent on a trade-weighted basis.

Several factors are providing short-term support to the dollar - the prospects of interest-rate cuts to help the US economy, repatriation of funds to the US and fears that a double-dip in the US economy would hurt other economies.

In terms of the euro-dollar rate, the euro has clearly moved out of its well-established $0.85-$0.95 range, which persisted, by and large, over the two years from mid-2000, into a higher $0.95-$1.05 range.

This latter range is more appropriate to the slower growth prospects for the US economy over the next one or two years.

As was the case with the lower range, we can expect plenty of volatility within this new higher range, with the likelihood that the euro will once again trade above parity.

John Beggs is chief economist with AIB Group Treasury