December 5, 2002
U.S. EconomyWhile the Fed has been exceedingly generous this year, we do not expect Mr. Greenspan to dress up as Santa Claus and deliver the U.S. economy another rate cut at the December 10 FOMC meeting. We still think that last month’s cut in the Fed Funds rate from 1.75 percent to 1.25 percent is not going to noticeably help the economy to speed up from its already charted course. On the other hand, as we explain below, further cuts in the Fed Funds rate could send the mounting trade deficits to new and worrisome heights. Based on the March03 Fed Funds futures, there is currently no sentiment for another FOMC rate cut.
The third quarter GDP was revised up to 4.0 percent. Consumer spending continues to drive the economy with 4.1 percent growth, mostly durable goods and more specifically automobiles. Business investment spending lost momentum during the third quarter with 3.1 percent growth, down from 7.9 percent in the second quarter. Business investments in structures continued to decline strongly. Residential investment is also showing signs of cooling off.
The outlook is still clouded by the uneven pace of the recovery. As we have said in previous analyses, the economy is following a quarterly zig-zag pattern of high and low growth rates. The latest Fed "Beige Book" report shows the economy grew slowly in October, with continued weakness in manufacturing. As we enter the critical Holiday retail sales season, consumers seem poised for a moderate increase in spending, but not enough to make retailers merry. Auto sales have slowed down dramatically, perhaps if auto manufacturers were now to lower auto prices or even offer negative interest rates, they might prompt consumers to keep buying more vehicles, but auto dealers should not hold their breath. We think the economy will have a hard time exceeding 2.75 percent growth next year. Of course, this does not take into consideration some of the external risk factors such as military action in Iraq.
On a positive note, inflation does appear to be tame for the time being. We continue to monitor the consumer price index (CPI), which has served for many years as the barometer of inflation, notwithstanding the New Economy theories concerning the appeal of a low and stable index such as the personal consumption deflator. Our 12 month moving average of inflation (CPI) shows a rate of 1.7 percent for this year, which we expect to move up to 2.75 percent next year. Even if we use the University of Michigan’s consumer inflation expectations of 2.5 percent, the real interest rate factor embedded in the five year note as of November was 0.5 percentage point, quite a bit lower than historical estimates of 3.25 percentage points. For this reason we still expect the long end of the yield curve to start moving up as the economy picks up a little more steam.
The consumer sentiment index as reported by the University of Michigan rose to 84.2 in November, up from 80.6 in October. While this may signal consumer disposition to continue to spend, it should be put in perspective with other indicators such as the level of consumer debt service payments as percent of disposable income, which has been rising since the mid-1990s. Should interest rates begin to rise next year, the quality of consumer debt may deteriorate.
With the year coming to an end, we want to take this opportunity to repeat for the "nth" time our concerns over the twin deficits, specially the huge external trade deficit and the risks it presents for the U.S. dollar. The cumulative 12 month trade deficit in September was $453 billion and rising quickly. The deficit has already caught up with the previous peak just prior to the 2001 recession. As the economy continues to expand, our insatiable appetite for imports will drive the trade deficit to dizzying heights and could trigger an ugly fall for the dollar as early as the first half of next year. A sharp depreciation of the dollar could lead the Fed to raise interest rates in order to defend our currency.
Latin American EconomiesIn Bolivia, the government of president Gonzalo Sanchez de Lozada is launching a number of initiatives to jump start the economy. Some bank analysts are concerned about the short-term impact on the banks from measures such as a compulsory debt rescheduling for highly leveraged corporations, incentives to increase lending by 5 percent, and a modification of the loan portfolio evaluation and classification methodology that would also lead to increased lending, but at higher risks.
The president-elect of Brazil, Lula da Silva, has yet to announce the names of key members of his new team. One of the most anticipated announcements is the appointee for the presidency of the Central Bank.
In the first nine months of the year, Brazil’s current account deficit narrowed significantly to US$7.3 billion from US$17.4 billion in the same period last year. The trade performance has also been highly favorable, with a trade surplus of US$7.9 billion versus US$1.3 billion last year. However, this impressive performance has been made possible by a plunge in imports rather than an increase in exports.
The Chilean economy continues to grow at a pace of 2.0 - 2.5 percent, which is better than many Latin American economies, but disappointing for Chile. Exports are providing most of the impetus. Export volumes have been increasing, but lower prices have depressed the value of their earnings.
The economy continues to expand at a slow but steady pace in Costa Rica, led by a rebound of the manufacturing sector and an improvement of free zone operations.
Inflation and the fiscal deficit have been growing in the Dominican Republic, as a result of energy price increases that have had an impact on transportation and electricity. The government has increased capital spending and is covering the fiscal deficit with external borrowing.
Former Army Colonel Lucio Gutierrez won the presidential elections in Ecuador on the second round. Colonel Gutierrez was one of the leaders of the military coup that deposed Abdala Bucaram.
El Salvador’s trade deficit narrowed in the first half of the year, thanks to a combination of a modest increase in exports and a decline in imports. Family remittances have been increasing, despite the recession and slow recovery in the U.S., where many Salvadorean workers live.
Partido de Avanzada Nacional (PAN) held its primary elections in November and elected Oscar Berger as its candidate for the presidency of Guatemala. Mr. Berger is a former mayor of Guatemala City, who was defeated by Alfonso Portillo in the last presidential elections.
Economic activity is still weak in Mexico. Consumer spending and exports to the U.S. have yet to recover. Because of sagging demand and strong inflows of family remittances, the current account deficit has been narrowing. Other positive developments in the external sector include the increase in tourism income and the continuous strength of foreign investment.
The Panamanian authorities have trimmed their GDP projections for this year to 1.0 percent. Free zone activity and the main employment generating sectors - construction, agriculture and manufacturing - remain weak.
The Peruvian economy should be among the regional winners this year. GDP growth averaged 4.7 percent in the first nine months of the year. Manufacturing production has been growing at an average rate of about 4.0 - 4.5 percent this year.