Rebalancing act

The past week's ructions in the currency markets are a sign of changing perceptions of the world economy

WELL before it happened, it looked obvious. America's economy is slowing; the Federal Reserve last raised interest rates five months ago; and the country has a vast current-account deficit. Europe's economies have been springing mostly happy surprises: the European Central Bank is almost sure to increase rates on December 7th (see article) and will probably carry on doing so next year. Asia looks strong as well, and Japan's central bank has been wondering when it will be safe to raise interest rates again. Sooner or later, the dollar had to fall.

And so it has. Against the euro, the dollar had been dropping, little by little, for more than a month before it broke through $1.30 on November 24th, going on to hit a 20-month low (see chart). Against the pound, on November 28th the greenback was at its weakest for two years. It slipped against the yen too, though it later made up the ground. Against the yuan—politically the most sensitive exchange rate these days—it continued a stately decline.

Markets have been pricing in not only changes in relative growth rates—notably America's and Europe's—but also their implications for monetary policy. This global rebalancing was emphasised this week by the OECD in its twice-yearly Economic Outlook. In the spring the OECD forecast that America's economy would grow by 3.6% this year and 3.1% next year; now it reckons on 3.3% in 2006 and only 2.4% in 2007. For the euro area, it has raised its forecasts, from 2.2% this year and 2.1% in 2007 to 2.6% and 2.2% respectively.

So far, America is following the OECD's script. A bevy of statistics this week pointed to a weakening economy. There was more bad news from the housing market. New-home sales fell by 3.2% in October, the first drop in three months, and the stock of unsold new properties continued to rise. Although sales of existing homes picked up a bit last month, here too the unsold stock increased, to 7.4 months' supply.

The message on prices was mixed. Officially, the median price of new homes rose in October; that of existing homes fell by 3.5% from a year ago, the biggest drop since estate agents began keeping records in 1968. Both numbers should be taken with a pinch of salt. They do not take into account changes in the type of houses sold, nor, for new homes, the incentives that builders offer.

The main reason for the dollar's jitters was evidence that the housing bust may be infecting the broader economy. Consumer confidence, as measured by the Conference Board, fell further than expected this month. Wal-Mart, America's biggest retailer, has had a dismal November. And judging by their orders of durable goods, businesses may be scaling back spending. Orders for capital goods, excluding aircraft and defence, fell by 5.1% in October, the first drop in six months.

The gloom was partly countered by unexpectedly rosy revisions to America's third-quarter GDP. The dollar firmed on November 29th as new figures showed output was up by 2.2% at an annual rate between July and September, compared with the original estimate of 1.6%. On careful inspection, however, the figures are less cheery. Much of the increase is thanks to higher inventories, which bodes ill for future output.

Pessimists argue that recession is just around the corner: Nouriel Roubini, of Roubini Global Economics, predicts a recession by the middle of 2007. That is still a minority view, but financial markets clearly expect things to get at least bad enough for the Fed to start cutting interest rates soon. The prices of federal-funds futures suggest that investors think short-term interest rates are likely to decline within a few months.

One person who does not sound gloomy is Ben Bernanke, chairman of the Fed. This week, in his first speech on the economic outlook since July, Mr Bernanke painted a much brighter picture. Yes, the economy was slowing, but this “deceleration” was “roughly along the lines envisioned” by the Fed in July. Mr Bernanke said output growth could be “modestly below” its trend rate in the very short term, but made clear that he expected the economy to be growing at its sustainable rate within a year. Far from hinting at lower interest rates, he noted that inflation was still “uncomfortably high”: “whether further policy action against inflation will be required”, he added, would “depend on incoming data”.

Such talk may burnish the Fed's inflation-fighting credentials but is unlikely to mean much. The economy is clearly slowing and the news on inflation is benign. The latest GDP figures revised down the deflator for personal-consumption expenditures, the central bank's favourite inflation gauge, to an annual 2.4%. The pace of wage and salary growth was also much slower than first reported.

America's interest rates are clearly not going up. Nor, however, are cuts imminent. Mr Bernanke's speech showed that he is not unhappy about the economy's deceleration. That suggests a bout of weak growth will not mean lower rates. So dollar bears may be right about the direction of America's economy, but wrong about the consequences for monetary policy.
Those chirpy Europeans

There are two sides to any exchange rate: Europe's prospects matter as well as America's. In 2006 the euro area looks likely to grow at its fastest pace for six years. That its GDP growth is modest by American standards, largely because of its slower population growth, is not the point: what matters is that this year it has surprised the soothsayers time and again. That has lifted its currency, and not just against the dollar. A euro now buys more yen than at any time since the single currency was created.

Detailed figures for euro-area GDP, published on November 30th, confirmed a slowing from a stunning second quarter to a much duller third. But the 0.5% growth in the third quarter—roughly in line with the zone's sustainable rate—seems to have been built largely on domestic demand rather than net exports. Europe may therefore be well placed to withstand an American slowdown.

By no means is everything in the euro zone wonderful: thanks in part to a fall in companies' stocks, French GDP was flat in the third quarter. But there are plenty of good signs, notably in the euro area's biggest member, Germany, which for many years was a source of unremitting misery.

Despite disappointing retail sales in October and weak wage growth, German consumer confidence is at a five-year high. It helps that unemployment is falling, as it did in November. Business sentiment is also strong. The index of current conditions prepared by Ifo, a Munich economic-research institute, is at a 15-year high; Ifo's expectations index is also on the rise. Granted, the economy may be flattered at the end of this year by people's anticipation of an increase in value-added tax in January, as they spend now rather than pay more later. Although a dip is likely once the tax goes up, the economy looks unlikely to buckle.

All of this, coupled with rapid monetary growth in the euro area, suggests that the ECB will raise rates not only next week but also next year: when and by how much may well depend on how the zone copes with Germany's VAT increase and a planned tax rise in Italy. With the doubts about America's growth and interest rates, this makes the euro attractive.

So attractive, perhaps, that some wonder whether its rise could clobber Europe's exports, slow its economy and persuade the ECB not to raise rates after all. That looks a long way off. David Mackie, of JPMorgan, says that the euro would have to rise to $1.43 to make the ECB raise rates by a quarter of a percentage point less than it would otherwise have done. With rates only at 3.25%, there may be much more than a quarter-point increase to come.

Even the euro zone's finance ministers, who met this week, do not sound perturbed by the currency's climb. France's Thierry Breton was an exception, but his nervousness was dismissed as a “Pavlovian response” by Nout Wellink, the president of the Dutch central bank and one of the ECB's rate setters. As long as it has a stronger economy, Europe seems ready to live with a stronger currency.