US economy tipped to stage modest recovery

THE United States is poised to engineer a modest but slow economic recovery while Europe is moving towards stagnation and Japan will slip deeper into recession this year and next, say economists from US investment banks Smith Barney and Morgan Stanley.

The US dollar will rise against the deutschemark and remain stable against the yen, while the Bundesbank will be forced to ease interest rates.

Both banks predict an easing by the German central bank in the next few months, totalling 200 basis points - or two percentage points - by the end of the year.

Last night the Bundesbank announced it would cut its discount rate by 0.25 of a percentage point to eight per cent and its more market-sensitive Lombard rate by 0.5 of a point to nine per cent from today.

Federal Reserve policy is expected to remain unchanged in the medium term at least, possibly easing towards mid-year.

While the fundamental trend for both short and long-term interest rates was down, said Smith Barney's Mr Mitchell Held, in the current economic environment, the Fed's interest rate policy was likely to remain unchanged.

But if the economy started to lag disappointingly over the next few months, then there could be room for a 25-basis point reduction in the Federal funds rate and a 50-basis point cut in the discount rate, he said.

The US dollar should rise against the European currencies, to 1.80 deutschemarks by the end of the year, both banks said.

Mr Held said US President Bill Clinton's package - if he could get it through Congress - boded well for the financial markets.

''As long as the economy can grow slowly enough to keep inflation under wraps . . . if you have an expansive monetary policy with a restrictive fiscal policy, that's the best policy combination for financial markets to behave well.'' Mr Held is forecasting an annual inflation rate of three per cent for this year and next, while Morgan sees the Consumer Price Index reaching 3.2 per cent this year and 3.3 per cent next.

In the near term, Mr Held said there might be a short-lived rise in long-term rates to 7.25 to 7.75 per cent, coming back down to seven per cent by mid-year and remaining at that level into next year.

Morgan sees rates trading in the 7.25-to-7.75 per cent range, driven at the higher end by concerns over the size of Mr Clinton's fiscal programme and at the lower end by perception of economic weakness.

Both Smith Barney and Morgan Stanley are predicting a gross domestic product (GDP) growth of two to three per cent for the first quarter of this year.

Morgan Stanley economist James Fralick expects two to three per cent real GDP growth in the first quarter, one to 1.25 per cent in the second, followed by three to 3.25 per cent in the second half of the year to average 2.6 per cent growth for the year. For next year, he expects three per cent.