August 15, 2002
U.S. EconomyThe FOMC decided to leave the Fed Funds rate intact at its regular meeting two days ago. This marks the fifth consecutive meeting, since last December, at which the Fed has not made any changes to its interest rate policy. Markets were generally expecting another quarter point reduction, as evidenced by the Fed Funds December futures, which are trading at 1.50 percent. We think this "everything will be alright once the Fed lowers interest rates again" view is somewhat naive in thinking that the economy can simply be fixed with another interest rate cut. If so, then the Fed should simply lower interest rates to 0.0% or even negative. We think interest rates have reached what economists call a "liquidity trap," which means that any further rate cuts will not result in increased economic activity, but in fact could trigger inflationary pressures or further erosion of the US$. We think the Fed will stay the course at the September meeting; although we still think rates will begin to rise before the end of the year due to turbulence in the currency markets among other factors.
In May, we coined the phrase the "TV recession," to describe the so-called recession that started in March of last year. It made for a good story: the economy went through a recession last year and policymakers crafted a successful recovery as we entered 2001 on an upswing. We think the economy is actually going through a difficult period, and that it only showed a notable slowdown last year, rather than a recession. As we had mentioned, we think the economy will go through a zig-zag pattern of high and low GDP growth rates this year; although there is a significant probability of a real recession.
The economy slowed down noticeably during the second quarter with GDP growth of 1.1 percent, down from 5.0 percent in the first quarter. There was a noticeable slowdown in consumption expenditures, particularly nondurable goods, which declined 0.6 percent. Interestingly business fixed investment in machinery and equipment posted a positive growth of 2.9 percent, the first positive growth figure in some time; although investment in new structures has been falling at an annual rate of 14 percent during the first two quarters of this year. Imports showed an unusually strong growth of 23.5 percent in the second quarter, in contrast to a 15 percent expansion in exports. At the same time, Federal government expenditures continue to roar ahead at 8.0 percent, while state and local governments showed a decline of 1.1 percent.
The outlook for economic activity continues to be cloudy. At best we think the economy will continue its zig-zag pattern of growth. At its Monetary Policy Report to Congress on July 16, the Fed forecast GDP growth of 3.5-3.75 percent for 2002. We think this is an optimistic view, our forecast is for 1.5-2.0 percent GDP growth, with the possibility of a recession. The latest reading of the University of Michigan’s Consumer sentiment index of 92 is still healthy, although significantly below the peak of 112 reached in 2000. Theories of negative wealth effect from the recent drop in the stock market indicate further weakening in the consumer sector. Interestingly we think that the latest market declines bring the S&P500 total return index to a more normal ten year average rate of return of 12.6 percent. Remember, the stock market is a long-term investment.
We think the yield curve will flatten and shift up moderately by the end of the year, mostly as a result of an increase in short-term rates. There are several reasons why we think interest rates may move up. First, the current weakness of the dollar. We have been warning of a significant decline in the value of the dollar since last year. Our assessment is based on the Fed’s actions to lower interest rates. Last year’s FOMC actions to lower the Fed Funds rate from 6.50 percent to 1.75 percent resulted in a sizeable increase in domestic liquidity. While the Fed has been quick to point out that it has not had any inflationary effects, it has ignored the following very worrisome trend: the increased liquidity has gone out the back door through a surge in the external trade deficit. In other words, inflation has not accelerated because people have spent the increased liquidity on imported goods and services. We think this will exert strong downward pressures on the dollar. A second factor is inflation. The CPI is currently running at an annual rate of 1.8 percent and in our view, will rise to just under 3.0 percent in 2003. Consumer inflation expectations, which have been behaving in an erratic manner are now at 2.7 percent. In November of last year consumer inflation expectations had dropped to an unusually low figure of 0.4 percent, a sign that markets are very confused. Finally, a third factor is the rising fiscal deficit. The Federal government budget posted a large deficit in the first quarter of this year, and this trend is expected to continue. Expectations of higher deficits could result in upward pressures on longer term interest rates.
We have been sounding the alarm on the external deficit for some time. The monthly trade deficits have been rising again, and the merchandise trade accounts could reach an unsustainable deficit of about 5.0 percent of GDP this year. This will be one of the principal factors behind further slippage of the US$.
Latin American Economies Brazil obtained a US$30 billion stabilization loan from the IMF, in exchange for stringent fiscal targets next year. Brazil will immediately start tapping the funds for a total of US$6.0 billion, in order to help prop up the battered currency. In the political front, Lula and Ciro Gomes are far ahead the official candidate, Jose Serra, in the opinion polls.In Colombia, new president, Alvaro Uribe, is making good on his promise of a hard line stance against the guerrillas. He has imposed a 90 days stay of emergency in the nation and a war surtax to finance the war effort.
Preliminary official estimates indicate that Dominican Republic’s economy grew by about 6.0 percent in the first semester of this year. However, free zone exports fell by 4.3 percent during that period. The main employment generators in the free zones - textiles, garments and footwear - reported the largest declines in exports.
Output of maquilas in El Salvador grew by 4.9 percent in the first six months of this year.
Family remittances to Guatemala reached a record US$781.4 millions in the first seven months of this year. By contrast, family remittances totaled US$592.3 millions in 2001.
The political crisis engulfing Nicaragua is taking a turn for the worse. Former president Arnoldo Aleman, using his influence as chairman of Congress, sent legislators off on vacations just when Congress was about to debate a motion to strip him of his immunity. Aleman is under investigation for alleged fraud committed during his tenure as president.