Fed Chairman Alan Greenspan’s congressional testimony on February 13, cast some light on the rationalization of their unusual interest rate cuts in January. Mr. Greenspan explained that because businesses are now armed with highly sophisticated information technology, they are responding much more quickly to any slowdown in consumer demand or a buildup in inventories. Based on December information, which implied that manufacturing production was falling precipitously, the Fed decided to act aggressively in January. We continue to think that the Fed actions to cut rates in January were too aggressive, and risk either spooking consumers or adding fuel to inflation. See our StratAlert dated February 2 for additional comments on the risks raised by the latest Fed actions, which also happen to be out of character with the approach they have taken in the past.
Interestingly, Mr. Greenspan’s testimony points to some inconsistencies, which raise concerns about the Fed’s new strategy to influence market psychology. As he stated, new advanced technologies have "engendered a more rapid adjustment of capital goods production to shifts in demand that result from changes in firms’ expectations of sales and profitability." This so-called super-rapid response is what led to the Fed’s forceful and aggressive actions. However, we think this can be interpreted in another way. First, the quick response refers to how businesses react to changes in their expectations. So the problem is really the change in their expectations, not the speed of adjustment. The Fed needs to establish that a dramatic change in business expectations has occurred, in order to justify their argument that the economy stalled at the end of last year. Second, if the speed of adjustment has increased, then this implies much greater volatility in the economic environment, which would call for more caution in making changes in monetary policy. In other words, one month businesses could have low expectations, and then the next month their outlook could improve, resulting in wide swings in business activity. In this situation, a sharp cut in interest rates could exacerbate the volatility in the financial markets and the economy. Another potential flaw in the Fed’s view of technology-driven super-fast adjustments by businesses is an "old" economy concept: "the higher they rise, the harder they fall." One reason why the economy is much slower, although the growth rate is still very healthy, is that the U.S. economy has slowed from a very fast rate of growth.
Another apparent inconsistency in Mr. Greenspan’s testimony is that if the U.S. economy has stalled as he said, why is the Fed projecting a very healthy 2.25 percent growth for the U.S. economy this year. The Wall Street Journal’s polling of well-known forecasters shows a GDP growth forecast of 2.1 percent, which is not bad for an economy that is supposed to be faltering.
We think the Fed may lower the Fed Funds rate up to another 50 basis points. Based on the Fed’s emphasis on forceful action, it is possible they will cut the rate before the next meeting. This is part of their attempt to influence market psychology. However, we think this risks fueling inflation further. This may not turn out to be a good year for the Fed. Latest data indicate first, that unit labor costs are accelerating, up 4.1 percent in the fourth quarter of last year, compared to 3.2 percent in the third quarter; and second, retail sales climbed 0.7 percent in January. This is in line with what we had indicated in our February 2 StratAlert, that the economic data is still mixed on whether we are indeed in a recession as the Fed seems to indicate. This morning’s release of the January producer-price index shows an increase of 1.1 percent, which is consistent with our earlier predictions.
A few comments on the tax cut. We think a tax cut is necessary for a very simple reason: Americans are over-taxed. The purpose of the government is not to run surpluses, but to BALANCE THE BUDGET, hopefully efficiently. The magnitude of the tax cut is unclear, since much of the debate hinges on highly questionable projections of the surplus. For example, one key assumption is no recessions for twenty years (this includes the 1991-2011 period). How the cut is to be distributed will ultimately depend on Congress’ incomes policy, and this will be determined through the political process, thus economists will not make the call on this issue.
There is some sentiment that a tax cut could forestall a recession. However, this is not the purpose of the tax cut, which is to lower the tax burden on the economy, particularly for small businesses and for wage earners. Economist John Maynard Keynes originally proposed fiscal policy to help an economy with high unemployment rates. Clearly with 4.2 percent unemployment at the end of a very long and dynamic expansion period, the U.S. economy is not suffering from a lack of fiscal support. In this case, further spending stimulus could actually aggravate inflationary pressures.
Latin American EconomiesWe also think the $5.6 trillion surplus figure is a misrepresentation, since it represents future values of the surplus. Most businesses that make investment decisions typically look at the net present value of future profits generated by that investment. We think the surplus should be viewed in the same context. Using a discount rate of 6.33 percent, the present value of the projected figure is $3.8 billion. Unfortunately, the CBO estimates are not very informative as to the impact of a U.S. recession on the surpluses. Using their own coefficients of the relationship between lower economic growth and the reduction in the surpluses, we calculated the surpluses based on an average GDP growth rate of 2.5 percent. In this case the nominal surpluses fall to $4.3 trillion or a present value of $2.9 trillion. These figures indicate that the projections are subject to a fairly large margin of volatility.
With so much talk of the budget surplus and tax cuts, markets have paid little attention to the bulging trade deficits. As we have said in past commentaries, the U.S. trade deficits have reached unsustainable levels. Last year, the current account deficit was about 4.7 percent of GDP. The large deficits pose potential problems for the US dollar as well as for the management of monetary policy. To put this problem in perspective, we calculated the projected current account deficit for the same period as the budget surplus projections, 2002-2011, using CBO’s own GDP forecast for this analysis, and under this scenario the cumulative current account deficit is a whopping $4.8 trillion!
The financial assistance package, recently granted to Argentina by multilateral agencies and the international financial community, amounts to $40.0 billion to be disbursed in three years. About $20.0 billion will be disbursed this year, to cover Argentina’s debt service payments in 2001. The package includes $7.0 billion in debt swaps to lengthen maturities.
The Argentine government also announced a $20.5 public works program to improve the infrastructure and to generate about 400,000 new jobs.
Bolivia plans to exploit its geographical position to become a commercial corridor for goods in South America. For that purpose, the government is prioritizing economic integration with its neighbors and Mercosur. The government expects growth of between 2.0 - 2.5 percent this year.The Brazilian economy keeps growing steadily. Unemployment fell to 6.4 percent, a 36 month low. Interest rates are expected to decline moderately.
Economic performance remains satisfactory in Chile, while charges against former president General Augusto Pinochet and violations of human rights under his government have taken center stage.
The Colombian president Andrés Pastrana met with the FARC leader, Manuel Marulanda (Tiro Fijo), in an effort to jump start the stalled peace negotiations and to avoid an all out civil war. President Pastrana faces strong criticism at home for his leniency toward the guerrillas. Alvaro Uribe, of the opposition Liberal Party, a proponent of a tougher position against the guerrillas, is now leading the popularity polls in Colombia.
The popularity of president Rodriguez has been increasing in Costa Rica, in the wake of an improved economic climate and greater foreign investment.
Preliminary estimates indicate that Dominican Republic registered 8.5 percent growth last year, the fastest in the region. Growth should slow down next year as the U.S. economic slowdown takes a toll on tourism and assembly exports. Interest rates are expected to fall moderately in the next few months.
The indigenous population put an end to 10 days of widespread protests in Ecuador, after president Noboa agreed to keep heavy subsidies on the price of fuel and cooking gas, until the end of the year.
Another earthquake wrought devastation in the capital city of San Salvador in El Salvador yesterday.
The Guatemalan government and business and community leaders will join forces to stem the rise of criminal activity in the nation. Exports of other non-traditional agricultural products will be actively promoted this year. A greater effort will be made in the next three years on exports of agro-industrial products.
In Honduras, the government has indefinitely postponed any attempt at privatization. The attention centers now on the electoral process. The candidacy of Ricardo Maduro, is still being challenged by most political parties, on the grounds that he was actually born in Panama, which disqualifies him for the presidency.
The conservatives and smaller political parties in Nicaragua are concerned about the effect of the political pact between liberals and sandinistas, over a year ago, which skewed the electoral laws in their favor. After the sandinista’s impressive show of popular support in the last municipal elections, the emphasis is now in stopping them from gaining power.
Panama’s economic activity is lackluster, but foreign trade related operations, the mainstay of the economy, are performing very well. Cargo activity grew by 7.0 percent last year.In Peru, former president Alan Garcia has thrown his hat in the ring. The field of presidential hopefuls is large. Alejandro Toledo continues to lead in the polls.