December7, 2001
U.S. EconomyAfter lowering the Fed Funds rate by 50 basis points to 2.00 percent on November 6, the Fed is signaling that it will lower the rate again at its upcoming December 11 FOMC meeting, the last for the year. The markets are betting on a quarter point cut to 1.75 percent, and we concur with that view. In their November 6 release, the Fed had emphasized that heightened uncertainty and concerns over worsening business conditions pointed to high risks towards further weakness. At the same time, Fed officials have repeated that there are currently no inflationary risks. On the other hand, it is possible that the Fed could go further in lowering the Funds rate possibly to below 1.00 percent as the recession continues, mainly because the Fed considers that inflation poses no threat to the outlook. In 1954,when inflation dipped below 1 percent, the Fed Funds rate also fell below 1.00 percent. However, we differ with the Fed on the issue of inflation.
In October, the CPI posted a 0.3 percent decline. Curiously, consumer short-term inflation expectations, as measured by the University of Michigan consumer survey, dropped sharply from 2.8 percent in September to 1.0 percent in October. This type of swing in expectations is unusual. On the other hand, we think the CPI will average about 2.8 percent this year, and could edge up in 2002. We avoid using the "index of the day," as is now the popular venue: the CPI core, the consumer expenditures deflator, and any combination of other measures. Interestingly, the price index used by the US Treasury for the inflation-indexed bonds is the CPI. The wild card for the inflation outlook will be oil prices. From a high of $34/ barrel in November of last year, the average price fell to $19.67 last month. Further easing of oil prices would bring down inflation below our forecast.
According to the National Bureau of Economic Research, the recession started in March of this year. Their decision is based on an analysis of numerous economic indicators, although one of the participants in this process commented that the events of September 11 were instrumental in triggering the recession. The designation of the dates for a recession by NBER were arrived at by a committee, which incorporates both quantitative and qualitative factors in its decision. The third quarter GDP preliminary estimate showed a decline of 1.1 percent, versus the original advance estimate of a decline of 0.4 percent. This was the third consecutive quarter of significant draw-downs of inventories by businesses. Business fixed investment was down by 6.3 percent, following a decline of 9.7 percent during the second quarter. Both personal and government consumption expenditures slowed sharply. Expenditures on durable goods was up only 0.7 percent after growth of 7.0 percent in the second quarter. We expect a drop of 2.5 percent for the fourth quarter GDP, bringing the year average rate to 1.0 percent, down from 4.1 percent in 2000. The recession will continue through the first half of next year, and assuming a recovery during the second half, GDP for the year will be down 0.5 percent.
Based on recent indicators, this recession will be a bit harsher than markets anticipate. The unemployment rate climbed to 5.4 percent in October, and could exceed 6.0 percent during the first quarter of 2002. Consumer sentiment has fallen since September 11. The U Michigan index was down to 82.7 in October, from 91.5 in August, and a peak of 108 in July, 2000. Concerns about terrorist attacks as well as worries over job losses could result in further belt-tightening of expenditures. Retailers are already bracing for a weak holiday sales season. The stock market remains vulnerable, the S&P total return index has fallen 25 percent during the past 12 months. The housing market has begun to soften. Commercial real estate is starting to experience higher vacancy rates. This unsavory mix could become more problematic for the economy during the first quarter of next year.
Despite the recession, the balance of payments deficit has not shown a significant response. Part of the problem has been the weakening global economy, so that exports have also declined. We expect a trade deficit of $439 billion this year, which is moderately lower than last year’s $452 billion deficit. As percent of GDP, the trade deficit will fall to 4.1 percent this year, down from 4.6 percent in 2000. Assuming a healthy cut in imports next year, the merchandise deficit could decline to a still high 3.8 percent of GDP in 2002. We think the external deficit has become a structural problem that could result in significant weakening of the US$. With a recovery in the U.S. during the second half of next year, the deficit could surge again to even higher levels. The U.S. military operations overseas will also result in a significant increase in the services deficit.
The good news is that the Fed’s short-term interest rate cuts and the recent fiscal stimulus should give us something to cheer about during this holiday season. The bad news is that uncertainties about the future will put upward pressures on long-term interest rates, which are determined by the real interest rate plus expected inflation. We think there are several factors that will push up the long-end of the rate spectrum: first, concerns about a long military campaign to weed out terrorists and fears of more terrorist attacks; second, a rising fiscal deficit, as we had predicted, the ten year surplus has turned into a rising deficit; and third, the large external deficit could result in a lower US$, and thus compromise the Fed’s ability to manage interest rates. We think real interest rates will average 3.5 percent, which is compatible with recent trends in rates on inflation-indexed U.S. Treasury bonds. Based on our inflation forecast of 2.8 percent, the long-end of the rate spectrum should thus be in the range of 6.00 - 6.50 percent, this implies a significant steepening of the yield curve.
Recently, analysts have been musing over the possibility of a stagnation syndrome – a la Japan. We do not perceive this as a realistic scenario. In fact, the U.S. economy is still showing signs of resilience. The equity market fallout will probably bring the market rate of return closer to the normal, or long-term trend rate of 13 - 14 percent per annum, which is a far cry from a melt-down. The U.S. is a very open economy, which assures that businesses remain competitive in the world markets. And finally, dynamic technological changes combined with successful product innovations will continue to drive a healthy growth of productivity in the U.S.
Latin American Economies
Highlights of the desperate measures introduced by economic minister, Domingo Cavallo, this week in Argentina: (I)bank withdrawals and transfers abroad are limited to $250 per week and $1,000 respectively; and (ii) severe restrictions to cash transactions. These measures were triggered by the acute liquidity crunch in Argentina, arising from a massive outflow of bank deposits. The purpose is to prop up the shattered Convertibility Plan and to avoid a collapse of the banking system. However, this latest package is actually bound to deepen the profound economic crisis in Argentina, because it further hinders consumer spending, without offering any solutions. Our long standing position has been that no improvements will occur until there is a devaluation of the currency (see out Special Alert Argentina).
The principles of the Convertibility Law have already been violated: first, there are two exchange rates, the official and a trade rate, which is controlled by the Ministry of Economy; second, there are three money supplies: pesos, US$s, and Notes issued by the Provinces, which are being used as a means of payment, and these Notes do not abide by the monetary rule under the Convertibility Law; and third, the recent measure to in-effect "freeze" bank deposits has eliminated free convertibility from pesos to US$s.
We think dollarization would result in a collapse of the economy. Proponents are arguing that with dollarization, Argentina’s economic problems would disappear overnight; however, we think this is an exaggeration that is meant to give people a fall sense of security. In order to dollarize effectively, Argentina must be roughly on the same level as the U.S. economy, and unfortunately, there is a very wide gap between the two economies. Many analysts claim that dollarization makes sense since more than 50 percent of bank deposits are already in US$s. We think this statement is inaccurate, since there are no real dollars backing the bulk of those deposits! The accounts are denominated in US$s, but they were not created with an actual transfer of US$s. This reminds us of the famous Mex-dollars of 1982.
In response to continued economic weakness, the Bolivian government introduced a new reactivation package, which includes an interest rate cut, assistance to businesses through a debt restructuring program, and a job creation component. By government decree, business lending rates will fall from 16 - 20 percent to 9.5 percent. Public investment in infrastructure improvements seeks to create 70,000 jobs in the next 14 months.
Brazil’s accumulated trade balance for the January - October period shows a surplus of US$1.5 billion. Exports were growing at 7.3 percent and imports at 4.3 percent. The steep fall of the real this year has helped Brazilian products in the world markets, while at the same time, stemming the flow of imports. The resilience of imports, despite sagging domestic demand, is due to imports of capital goods for the energy sector.
The Chilean monthly indicator of economic activity showed annual growth of 3.3 percent through August. Industrial production was growing by a scant 0.8 percent through September, mainly due to the steep fall of 16.3 percent in consumer durable goods production
The Costa Rican government expects a very difficult year ahead with increasing unemployment and no growth in real salaries.
The government expects growth of 3.5 percent this year in the Dominican Republic. However, up to September, GDP growth had reached only 1.7 percent and the worst of the U.S. recession, which will heavily affect the Dominican Republic, will probably develop in the fourth quarter of this year. Tourism has been falling since April and aggravated by the events of September 11. During the January - August period tourist arrivals fell by 0.5 percent with respect to the same period of the previous year. By contrast, arrivals grew by a strong 15 percent during January - August 2000. The authorities also reported a steep fall in arrivals in September and October of 16.4 percent and 22.1 percent respectively.
The cumulative trade surplus through September vanished in Ecuador, due to a plunge of 18.2 percent in oil exports. Total exports were falling y 7.3 percent, while imports were growing at an exceptionally strong pace of 45.8 percent. Imports are being pulled by the rebound in domestic demand this year coupled with a still high domestic inflation rate.
El Salvador is recovering nicely from the natural disasters that hit early this year. The reconstruction activity is shielding the economy from the impact of the current global economic deceleration.
There is a mood of stagnation in both the political and economic environments in Guatemala. According to the index of economic activity, the economy grew by a paltry 1.0 percent through August.
In Honduras, Ricardo Maduro was elected president, despite the controversy surrounding his place of birth.
Economic activity in Mexico contracted by 1.6 percent, under the burden of sagging external demand for Mexican exports and the slump in the tourism industry. The authorities expect six more months of difficulties ahead.
The Lima Chamber of Commerce estimates that economy continued to expand in October, led by mining. This would be the third consecutive month of economic expansion for Peru.