April 17, 2003
U.S. EconomyAs we predicted, the Fed did not change the Funds rate at the last FOMC meeting, and we expect the same for the May 6th meeting. On the other hand, since the economy continues to show signs of weakness, we think there is a possibility that a Greenspan Fed, prone to sending strong signals to the market, may opt for a dramatic statement by further lowering the Fund’s rate. However, we think economic sense will prevail, particularly in view of the inflationary risks as well as the towering trade and fiscal deficits, and the FOMC will stay the course. The September Fed Funds futures are trading at 1.15 percent, thus markets are expecting an additional cut in the rate.
Recent statements by Fed officials have piked our curiosity regarding a possible new monetary policy strategy to try and bring down long-term interest rates. We think this would be a big mistake. The Central Bank has traditionally been faithful to its practice of targeting short-term interest rates. Scores of Fed studies have confirmed that monetary policy cannot materially alter long-term interest rates, since these are determined in large part by inflation expectations and investors’ time preference for money as well as their risk premium. Monetarists sometimes use a simple model of an economy: if you lower interest rates, the economy grows faster, or if you push another button, the economy grows faster. The Fed's appeal to lowering long-term interest rates should be tempered by the surge in the Federal government’s borrowing requirements expected during the next few years. The huge fiscal deficits will drive up the risk premium associated with long-term interest rates
Just as the tragic events of 9/11 pulled the economy decidedly into a recession, the uncertainty over the war in Iraq at the end of last year, and the decision by the President to commence with the military campaign in March, have sapped the recovery’s momentum. We think there is a risk that the recovery will stall this year, before the economy starts to putter by the end of this year, followed by a more healthy pace in 2004. We expect GDP growth of 2.24 percent this year, followed by 3.4 percent in 2004.
Since January, consumers have held back on spending not only because of the War, but also because of unsettling economic fundamentals. The University of Michigan’s consumer sentiment index declined in March to 77.6, from 79.9 in February, and well below the March 2001 level of 91.5, just prior to the start of the recession. Using an eclectic approach to consumer economics, we posit the following factors as key determinants of consumer sentiment: 1. Unemployment rate; 2. Return on the stock market; 3. Percent change in home prices; 4. Interest rates; and 5. The Homeland Security terror alert index (red, orange, yellow, blue, or green). Yesterday’s announcement that the terror alert index was lowered from orange to yellow bodes well for consumer sentiment, along with the continuing positive influence from low interest rates and rising home prices.
As we have mentioned in previous Briefings, housing construction and refinancing have helped to stand the economy up on its feet. However, there is a limit to refinancing, and we may be approaching the saturation point. On the other hand, industrial production appears to have entered into a double-dip recession. After falling continuously from July 2000 through December 2001; production has again been on a downtrend since August of last year.
Despite the Fed’s inclination to lowering long-term interest rates, we think the 10 and 20 year bond rates will bottom at around 4.0 percent and 5.0 percent respectively. As inflation picks up this year, with our forecast of a year average rate of 3.0 percent, long-term interest rates are bound to increase another 75 to 100 basis points. The University of Michigan’s consumer sentiment survey shows inflation expectations running at 3.1 percent in March, up from 2.5 percent last December. As we have been warning for some time, the combination of a falling dollar and surging fiscal deficits is bound to push up the risk premium associated with the long end of the interest rate spectrum sooner than later.
Latin American Economies
An improved economic performance in Argentina, with GDP growth of 4.9 percent in the first quarter, has strengthened the peso. The harder an economy falls, the higher it bounces back. The authorities intend the keep the exchange rate against the dollar at around pesos3/US$.
Carlos Menem, Nestor Kirchner and Adolfo Rodriguez Saa are in a virtual tie at the top of opinion polls, just a few days ahead of the presidential elections. A second round will probably be necessary.
Bolivia’s new 2003 fiscal budget calls reductions in spending and fiscal downsizing and eliminates the initially proposed tax increases. Emphasis will be on public investment in infrastructure, in order to create more jobs.
A recently signed Stand-by Agreement with the IMF establishes targets for 2003 as follows: GDP growth of 2.9 percent; budget deficit of 6.5 percent of GDP, down from 8.8 percent last year; and inflation of 2.8 percent.
Lula’s first 100 days as president of Brazil have succeeded in calming investors’ fears. The incoming president has shown support for fiscal discipline, respect for financial obligations and a desire to continue with structural reforms. However, not much has been said about privatization.
The president of the Chilean Central Bank, Carlos Massad, tendered his resignation, as a result of the financial scandal involving the financial firm Inverlink, Corfo (State-owned development bank) and Mr. Massad’s long-time secretary. However, Mr. Massad has not been personally implicated in the scandal. President Lagos has proposed the highly respected economist, Vittorio Corbo, as his replacement.
Retail sales for the first quarter were disappointing in Colombia. President Uribe obtained a 68 percent approval rating in the latest opinion polls.
The Index of Economic Activity in Costa Rica averaged 4.4 percent in the past two months. It has remained above 4.0 percent since November.
The U.S. proposed that the Dominican Republic join the current negotiations for a trade agreement with Central America. Both countries want to negotiate a special clause within the agreement, to address specific issues between the two countries. The Dominican Republic has obtained the support of four Central American countries for the negotiations.
Ecuador’s government does not intend to rejoin the OPEC. According to the authorities, the recent increase in oil prices has provided a cushion of $100 million to the economy.
The Index of Economic Activity in El Salvador increased buy just 1.3 percent in the first two months of this year. The electric power sector was the best performer with 6.4 percent growth, followed by construction with 2.8 percent, and manufacturing with 2.7 percent. Worst performers were finance with a fall of 9.9 percent and transportation with a decline of 6.9 percent.
Family remittances to Guatemala amounted to UD$452 million in the first quarter of this year. They are on track to at least match the US$1.6 billion posted last year.
Mexican authorities have trimmed their initial forecast of 3.0 percent growth for this year to 2.5 percent, in view of growing uncertainties with respect to the strength of the U.S. economy this year. The new estimate is more in line with the 2.3 percent foreseen by the IMF.
Panama managed to grow a scant 0.8 percent last year. Growth this year should be spearheaded by construction and an improved export performance.
In Peru, industrial production rose by an estimated 4 - 5 percent in March. Best performers were textiles, construction and paper.
As a result of foreign exchange controls in Venezuela, international reserves are rising. Nevertheless, as with its predecessor RECADI in the early 1980s, the current FX controls regime is not sustainable. President Chavez has also been putting pressures on the banks to lower rates, voluntarily or by decree.