Hamish McRae: State of the Union's fine ... but look at the state of the dollar

Dollar jitters; stock market jitters; and of course war jitters. President Bush's State of the Union message seems to have achieved its primary aim of pulling US public opinion together behind the President. But the international financial markets are a harsher audience and their judgment will only gradually emerge in the coming weeks. Still, the President seems to have won domestic support and that is a start.

Peering ahead, the markets will need to be comfortable about the answers to two important medium-term questions regarding the US economy before that can move forward. One is how the tax cut will affect the economy; the other, at what level the dollar is likely to level out.

The positive response to the State of the Union is important for the tax package, for it suggests that this will get through Congress in something like its present form. In the US liberal press there has been a fair amount of griping about the plan, partly on the social grounds that it will benefit the relatively rich and partly on the grounds that it is an inefficient way of boosting demand.

The view among the professionals on Wall Street, however, is more positive and that bodes well for the future. For example the latest commentary from JP Morgan Securities is that this is "good economic policy. It boosts long-term growth incentives, yet also provides short-term relief".

Their view is that it will add between one and two percentage points to growth for the next couple of years and that if the acceleration of tax-rate cuts wins congressional approval, the impact could be felt as early as this summer. Because much of the plan is merely bringing forward cuts that were already in the pipeline, they also argue that the long-term impact on the budget deficit is limited.

You can see the projected impact in the bottom left-hand graph. Add the cost of the war to the tax cuts and the hit in the years through to 2007 is pretty big. But after that, if (a big "if" to be sure) these figures are right, the hit would become minimal. At some stage the US budget deficit has to be pushed back towards surplus and as long at that need is accepted, rolling it back a year need not matter too much.

But will it really add much to GDP next year? You can see what has been happening to real personal disposable income and to real wages and salaries through the 1990s in the graph alongside. Wages and salaries have just taken a bit hit through 2001 and 2002, but RPDI was supported by tax cuts and remained positive. Now it should get another spike upwards from advancing the next bout of tax cuts, helping hold up demand until wages and salaries recover. Well, that is the theory and assuming wages so recover all should be fine. If they don't – well, a lot of things go wrong if that happens.

Put at its simplest, the tax cut ought to give a decent push to demand through to the end of 2004 at an acceptable cost to the deficit. After that there really does need to be a self-sustained recovery: you cannot puff up an economy with tax cuts forever. But 2005 is a long way off.

Meanwhile the US has to cope with pressure on the dollar. The new Treasury Secretary, John Snow, has just said that he favours a strong dollar, which is better than saying the opposite. But the fact remains that the dollar has fallen relentlessly over the last year. But is this the result of the external deficit, lower capital inflows, worse growth prospects ... or fear of war? The top right graph plots the dollar since last April against its performance ahead of and during the Gulf War. As you can see the dollar has fallen further and longer now than it did that time around. But note how the dollar bounced back once the war had begun. It continued to rise when it was clear that the war would be successful.

It is dangerous to take one conflict as a proxy for another. The objectives are less clear-cut, the probable coalition in support of the US narrower, and the underlying situation in the Middle East more tense. But the bounce is instructive.

HSBC, which drew that chart, takes the view that while there is likely to be a bounce, the dollar is set in a longer downward trend. So a bounce should be taken as an opportunity to get out! It is certainly a touch worrying that the relationship between the dollar and the euro, based on interest rate differentials, that operated through most of last year, now seems to be broken (lower graph). Indeed it looks as though the dollar is now lower than it "ought" to be, which in turn suggests a waning of confidence in it.

The trouble is, a point made here before, you can argue that all major currencies ought to be lower. The euro's recent strength is profoundly unhelpful for German exports. Sterling is generally thought to be overvalued. And the yen has to collapse to get some growth in Japan at last. Mathematically it is impossible for all currencies to go down and it may well be that in a few months, assuming a reasonable prospect of stability in the Middle East, that the dollar will again look the best of a bad bunch. We will see.

The big point here, surely, is that we are trudging through the typical uncertainties associated with the trough of a recession. If you look back to the early 1970s there was huge disruption because of the surge in the oil price and the wider inflationary pressures of the time. In the early 1980s there was another oil shock, companies going bust, and unemployment soaring. Here there was an untried government that was not at all sure it would survive. In the early 1990s there was the Gulf War and sterling's ill-fated membership of the ERM.

All these were global downturns; all affected different countries to some extent but the scale and nature of the blow was different depending on the viewpoint. The position now of the US economy is in some ways relatively stronger than it was during those previous downturns. In particular, productivity growth is better than in Europe or Japan, and the federal deficit so far at least, is narrower. True, the external deficit is wider but then investors have to ask which risk would they rather have.

The State of the Union address is one of those tournaments that the President has to win. The plain fact is that George W. has done so. It does not change the fundamentals in any way. But it helps rebuild confidence within the US and that is no bad thing.