The US economy is slowing down. That much we all know. The $64,000
question is how much is it going to slow down? Judging by the recent performance of developed bond and equity markets the vast consensus anticipates that the Federal Reserve will be able to engineer a “soft landing” by cutting the Fed Funds rate sooner rather than later and by doing so aggressively at that. What else do we know? Well, for starters we know that although active rate decisions are on hold the Open Markets Committee maintains a de facto bias towards raising rates again from the prevailing 5.25% level. We also know that with Congressional mid-term elections cropping up on 7th November the Fed is unlikely to want to rock the boat ahead of what is already looking like a very hard result to call. Thereafter it’s anybody’s guess.
Divisions within the Open Markets committee
We have commented, in the past few weeks, on divisions within the Open
Markets Committee itself and the fact that although Chairman Bernanke and sidekick Yellen have sounded pretty dovish of late. But for every positive there is a negative and a good number of Committee members continue to push a hard line. How this matter is resolved is likely to have profound implications, not just for the global economy but also for investors in financial markets. Far from a side show this is the game for which everyone wants a ringside seat.
At the recent Capital Economics annual conference we heard Mr Roger Bootle articulate why, in his view, it was premature to talk of early rate reductions. We are fans of Mr Bootle and think that his seminal work “The Death of Inflation” was truly prescient when released about a decade ago. However, one cannot rest on ones laurels for long in the financial markets and reputations have to be maintained continuously in much the same way as the Forth Railway Bridge must enjoy a neverending paint job. The justification for Mr Bootle’s views is set out below. But far from leaving the Clothworkers’ Hall hunched and fearful as might an ageing hound on the last trip to an indifferent vet, many acolytes just couldn’t help believing that this time maybe, just maybe, the great man might be wrong. Needless to say, if he were proved right the prospects for the world’s largest economy would be serious indeed.
How do energy prices affect headline inflation?
The key point to Mr Bootle’s presentation, from our perspective, was the basis of the relationship between core and headline inflation. The most obvious point to make is that headline inflation is impacted by rising or falling energy prices. The recent slide in energy prices has certainly taken some heat out of the headline inflation rate, but core inflationary pressures are expected to remain in evidence for some time. The basis of the relationship between the two lies, to some extent, in the elasticity (or inelasticity) of demand for energy on the part of the consumer. Certainly, other factors are at work in ensuring that core inflation remains sticky (rents etc), however, simply isolating consumers’ attitudes to energy prices does go some way towards explaining the nature of the relationship between the two.
Higher energy prices make people complain but, generally, they pay up (cars have to run and houses must be heated and lit). This leaves less left over for discretionary spending elsewhere on Main St. The converse is also true. Cut the price of energy and enjoy the benefits that a bulging wallet or purse confer. In this way it is thought that the combination of falling energy prices and buoyant consumer confidence should delay the point at which core inflation subsides.
Other influences on the Fed’s interest rate decisions
We accept the above (who couldn’t!) but we think that there could be more at work in shaping the Fed’s decisions than simply the relationship between headline and core inflation. For one thing, the Fed’s policy-setting remit is different to that of the European Central Bank of the Bank of England (both of which set policy to bear down on future inflationary pressure). The Fed is a nominal demand manager, setting rates broadly to ensure sustained economic growth without raising an inflation hare or startling the rabbit of unemployment. The US economic record indicates just how successful the Fed has been in achieving that goal (helped considerably by increased globalisation) under the auspices of Alan Greenspan. Dr Bernanke remains largely untested after just a few months at the helm, the markets seemingly happy to assume that policy will be eased in sufficient time to allow the supertanker to veer away from the rocks.
Despite the protestations of Fed vice Chairman Kohn (who sees no multiplier impact from falling US house prices), Greenspan (who wonders whether the worst of the housing market declines might be in the past), Philadelphia Fed Chairman Plosser (who thinks that economic activity might even accelerate…he is newly appointed!) and Chairmen Fisher, Lacker and Moscow (who fear a re-ignition of inflationary pressure) economic activity is already slowing fast.
Away from the rarified atmosphere of the Open Markets Committee rank and file staffers at the Fed take a less comforting line. Without the glare of the public eye these people predict that US activity will slow to below trend (perhaps 2.5% – 3.0%) in each of the next six quarters. If true, this should ensure that the, hard to measure, “output gap” widens again, creating the potential for both measures of inflation to fall further in the months ahead. According to exhaustive research by Merrill Lynch, the past sixty years worth of data shows that at no time has aggregate demand lagged aggregate supply for so long without the economy slipping into, at the very least, a technical recession.
To be fair, Capital Economics sees this and forecasts US growth of just 1.5% in 2007. But as growth slows the need for an aggressive policy response becomes even more acute. Slowing growth leaves little leeway if something goes wrong and little time for an orderly reduction in short rates. By leaving a monetary policy response for anything longer than the start of Q2 2007 raises the strong possibility of very aggressive base rate reductions indeed. Given the lag that exists between a rate change and its impact on the real economy one is left nursing the view that that might be too late to save the economy from something more serious.
By all accounts the impact of the boom in residential property in the US has been absolutely enormous. Significant follow-through advantages to the US economy accrued from encouraging low income renters onto the property ladder and then allowing them to spend against the rising value of their asset. According to the National Association of Realtors, over 40% of first time buyers put down no money on their house purchases in 2005 and that the percentage of the population owning their own homes rose above 70% for the first time ever! According to US statistics, more than 60% of the growth in the US economy over the past three years can be ascribed to the strength of the housing market and the related “wealth effect”.
Take that away and all of a sudden growth of c3.5% becomes something closer to just 2.0%, if that. Note too, “read across” conclusions from the US bond market. The process of earlier aggressive monetary tightening has helped aggressively to invert the Treasury bond yield curve. We accept that strong demand for medium and longer dated bonds may have helped depress yields at those durations but the Fed’s action has undoubtedly contributed to the curve’s overall shape. Again, a riffle through history reveals that Fed action aggressively to invert the bond yield curve proves the precursor to a “hard landing” 80% of the time. Typically, these “hard landings” have followed the point at which curve inversion becomes pronounced by four quarters…eyes down for Q2 2007!
Conclusion: high interest rates vs. recession
Senior Fed officials are seemingly caught between the rock of recession and the hard place of high interest rates to bear down on incipient inflationary pressure. Yes, the Fed fought off the threat of deflation in 2003 successfully. Yes, the Fed subsequently raised rates aggressively enough to head off a re-ignition of the inflationary forest fire. But now is not the time simply to sit back and see what happens. The disinflationary forces unleashed by a booming Asian economy have not and (despite some reports) will not go away. The risk is that by taking no action soon the next downturn, when it comes, could be very severe indeed…as a certain Mr Greenspan once speculated it would be!
By Jeremy Batstone, Director of Private Client Research at Charles Stanley