February 14, 2003
U.S. EconomyPreliminary Assessment of Mr. Greenspan’s Testimony on the State of the Economy:
Mr. Alan Greenspan, Chairman of the Fed, presented his semiannual monetary policy report to Congress on February 11, 2003. Overall, his views about the health of the economy focused more on the persistence of weakness and the adverse impact from the uncertainty surrounding the likelihood of war in Iraq. The following are some of our comments regarding Mr. Greenspan’s views on the economy.
Mr. Greenspan’s reference to a "choppy pattern" of economic growth is what we have been describing since the first half of last year. We have been characterizing this recovery as a "zig-zag" pattern of economic growth: strong growth one quarter, followed by weak growth in the next (See our previous StratAlerts in the Archive). This pattern is in line with our original views that the recession, which started in March 2001, could almost have been described as a growth recession, rather than an actual prolonged decline in output, except for the negative impact from 9/11. The implications from our assessment are that there is not likely to be much of a recovery since the economy did not experience a significant downturn in activity. Of course, slow growth still leads to higher unemployment and other painful symptoms of a recession. On the other hand, we think there is a likelihood of another dip in the economy triggered by an increase in interest rates during the second half of this year, which could deal a serious blow to the exceedingly robust housing construction and refinancing market.
Mr. Greenspan introduced a new term, economic flexibility, in describing the ability of the economy to adjust quickly to shocks, and which in his view, has helped to dampen cyclical fluctuations. He also ascribes the increased economic flexibility to globalization of economic activity. While he does not define the term economic flexibility, we think there is a direct connection to his earlier references to the so-called high-tech surge in the economy which made businesses much more responsive to changes in demand. For example, he has explained in the past how the use of sophisticated technology has allowed manufacturers to control inventories with uncanny precision, thus if consumers hold back on spending today, manufacturers would immediately adjust their output tomorrow in order to avoid an undesirable buildup in inventories.
While the concept of economic flexibility combined with the surge in high tech linked to higher productivity growth is an important factor in explaining the business cycle, we do not agree with Mr. Greenspan that this new phenomenon will dampen the business cycle. In our view, these structural economic changes could lead to greater volatility due to various factors including the following:
1. The zig-zag pattern of economic growth during the past two years is actually an indication of increased volatility. On the other hand, as we have explained in the past, the fact that businesses react with great speed to any changes in demand could actually be de-stabilizing For example, manufacturers may over-react to a temporary change in consumer demand by interpreting this change as if it was a permanent one.
2. Globalization has actually increased volatility. Since 1973, exchange rates have been fluctuating with increasing volatility. As we have explained, the dollar is now in a period of increasing volatility. The huge U.S. trade deficits are likely to introduce greater volatility in our economy.
3. As the Fed Chairman explained, the uncertainty over the possibility of a war in Iraq has sapped consumer confidence. However, we think that in the future, the likelihood of increasing global conflicts associated with the war against terrorism will result in periods of high uncertainty / anxiety and thus to greater volatility in the economy.
With respect to the President’s stimulus package, Mr. Greenspan coincides with our assessment last month, mainly that it was not so much a short-term package but rather a medium- to long-term stimulus, despite the fact that the stimulus is supposed to be short-term (see our StratAlert for January). For example, the measure to accelerate the tax rate cuts is not expected to materially affect taxpayers until 2004. On the other hand, we have to recognize that fiscal policy is likely to be more effective if the economy is in the middle of a deep recession, than if the stimulus is applied when the recovery has already started. For these reasons, it would appear that the Bush stimulus package is not likely to have a noticeable immediate impact on economic activity.
We were intrigued by Mr. Greenspan’s comment that the budget process calling for ten year projections was very useful. We think it has actually become a distraction which has resulted in reduced credibility in the budget setting process. For instance, Congress has invented a new tax and spend mechanism. Thanks to the ten year budget projections, legislators discovered how to spend today the surplus projected ten years from now. Another piece of mis-information communicated to the American people was that a dollar of surplus in the year 2010 was the same as one dollar of surplus today. We think long-term budget deliberations should be limited to technicians at the CBO, and leave the public debate for the issues affecting the budget in the next two to three years.
We were surprised that Mr. Greenspan’s testimony did not make any references to the heightened vulnerability of the dollar and the runaway trade deficits. The U.S. balance of payments is hemorrhaging, yet our monetary policy authorities are absolutely nonchalant regarding this topic. In fact, one of the explanations for the swelling of the external deficit is the expansionary monetary policy. The growth in the money supply resulting from the decisions by the Fed to lower the Fed Funds rate since 2001 has in part been leaking out of the economy via increasing demand for imports of goods and services. We still view the value of the Euro rising strongly by the end of this year, possibly to US$1.2 per Euro. Such a turn of events would undoubtedly affect interest rates and inflation in the U.S.
While the Fed Chairman views inflation as tamed, we think consumer expectations differ with him. The University of Michigan’s inflation expectations stood at 2.5 percent in December. The recent surge in oil prices will add to inflationary pressures, and combined with a surge in the government deficit as well as an unsustainable external deficit, these factors will bring about a steepening of the yield curve.
Latin American EconomiesGlobalization trends combined with hemisphere- wide free trade zone initiatives have been contributing to a greater degree of integration and interdependence among Latin American economies and with the US. Therefore, the slow and bumpy recovery in the US is having a direct impact on Latin America, especially Mexico. South America represents a greater risk at this moment. This area has been shaken by social and political turmoil, in addition to the external shocks provided by low commodity prices and a sluggish world economy.
Prospects for the region, including the US., have been clouded by the imminence of war with Iraq. Upheaval in the Middle East always raises the phantom of oil shortages and higher crude prices, which will have detrimental effects on the whole region. This is a more ominous concern now that the political turmoil in Venezuela has curtailed oil production in that country. A protracted period of war preparations and threats, without any action, have heightened uncertainty in general. This situation always tends to dampen investment and consumer confidence. It is happening in the U.S. and also in Latin America.
Uncertainty in Latin America is reflected mainly in the volatility of the currencies, which is affecting even traditionally stable currencies, such as the Chilean peso. We think that other than weak economic performance in the past two years, the currencies have been affected by a significant increase in the demand for dollars. Shaken by the social turmoil and sometimes surprising political developments in their own countries and by an uncertain economic outlook, individuals and businesses are seeking refuge in a stronger currency. We expect to see greater efforts this year, on the part of fiscal and monetary authorities, to prop up their currencies and to curb inflation.
Bolivian president, Gonzalo Sanchez de Lozada, sent his 2003 budget to Congress for approval. It includes controversial tax increases including a wider tax base, fiscal austerity and the expectation of greater oil and gas revenues. With aid from multilateral organizations, the government proposes a more vigorous public investment plan, with emphasis on infrastructure improvements.
Brazilian president Lula da Silva is now facing increasing criticism from his own followers, because of his moderate political and economic stance since taking office. Some leaders of his own party accuse him of continuing with the same economic policies of the previous administration.
Costa Rica managed to achieve moderate economic growth last year, coupled with another moderate export expansion.
The Dominican peso has been significantly weakening recently, in the midst of a liquidity crunch. Demand for U.S. dollars has outstripped their availability. The Central Bank has increased interest rates and taken a tighter monetary policy stance in response.
The key issue for Ecuador is the direction that the economic policy of newly elected President Lucio Gutierrez will take. President Gutierrez ran on a center-left platform; however, his initial declarations in office indicate a much more moderate approach to economic policy.
Guatemala continues to struggle with slow growth, and the upcoming elections heighten economic uncertainties.
Three straight months of bad weather raise the probability of a deepening coffee crisis in Honduras.
The Mexican economy has been basically following the same path as the U.S. economy. Economic activity has been generally up, since the second half of last year. However, growth has been dampened by slow employment growth and timid investment.
Panama has not officially published even preliminary economic statistics for 2002. Some government officials are hinting about another disappointing performance.
Peru is the exception with healthy economic growth last year of 4.4 percent boosted by export performance.
Venezuela continues to feel the impact from the nationwide protests against President Chavez. While the general strike was called off, the opposition is now focusing on the August Referendum on Mr. Chavez’s presidency. As we have predicted in the past, the government recently announced the imposition of foreign exchange controls. The Central Bank will now fix the exchange rate based on some arbitrary calculation.