July 30, 2003
U.S. EconomyAs we had predicted, the Fed lowered the Funds rate by 25 basis points to 1.00 percent in June. Nevertheless we expect that they will not lower the rate again at the August 12 FOMC meeting. The December Fed Funds futures is trading at about 0.95 percent, implying there is some market sentiment in favor of additional rate cuts. As we have said repeatedly, any further cuts in the Funds rate will have no noticeable impact on economic activity. The drop from 6.5 percent to the current 1.0 percent has had only a limited impact on economic growth, notably the housing finance market. Our principal concern is that while monetary expansion has not yet triggered a significant rise in inflation, it has contributed to a huge surge in the U.S. balance of payments deficit, which will continue to undermine the value of the dollar, and thus fuel inflationary pressures.
The Fed’s mid-year monetary report to Congress depicts a mixed picture of deflation and a healthy economic recovery starting in the second half of this year. One of the Fed’s principal concerns is that "the risk of an unwelcome substantial fall in inflation ... exceeded that of a pickup in inflation." In other words, that it is more likely for consumer prices to fall for a prolonged period, than for consumer prices to rise. Yet the same report goes on to predict a strengthening of economic activity during the second half of this year and through 2004. The monetary policy forecast calls for GDP growth of 2.5 - 2.75 percent this year (4th Quarter basis), followed by 3.75 - 4.75 percent in 2004. The Fed’s forecast implies that the economy will not post growth rates that would typically have been recorded during the first year of a recovery, which in this case would have been in 2002, until 2003 - 2004, in other words, the Fed is predicting a delayed but strong recovery. Interestingly, the predicted expansion is attributed to the "accommodative stance of monetary policy," with no mention of the role of an expansionary fiscal policy, particularly the recently approved tax incentives and higher defense spending . Instead, the report looks critically at the rise in the Federal budget deficit, and yet does not question the potential risks from excess growth in the money supply.
Despite all the focus on what the Fed can do to improve economic growth, monetary policy is not the only policy that matters. We think the Fed has done its job as far as helping to bolster the economy. Fiscal policy can now play a more active role. On the other hand, the slow recovery is also symptomatic of basic structural imbalances in the U.S. economy for which there are not quick fixes.
With the economy gathering momentum – recall our description of this expansion as a non-recovery expansion, we think inflation will begin to approach the historical average of 3.0 percent, based on the CPI without any adjustment gimmicks such as excluding food and energy. Our measure of the moving average CPI index shows an annual inflation rate of 2.2 percent in June, and is projected to move up to 2.4 percent by the end of this year. Consumer inflation expectations, based on the University of Michigan survey, are currently 2.1 percent. Once again, neither the historical trend of the index nor expectations point to the possibility of a prolonged decline in prices. We would welcome any data from the Fed to support the scenario of falling prices.
In November 2001, the National Bureau of Economic Research, the official arbiters of business cycles, announced that the recession had started in March of that year, and that no doubt the events of 9/11 had some influence on their decision to affirm that a recession had started. Interestingly, their news conference to announce the start of the recession could have doubled up as an announcement of both the start and the end of the recession. This month the Bureau announced that the recession had in fact ended in November 2001. Curiously, after the original announcement by the Bureau in November 2001, the GDP statistics continued to show only one quarter of negative GDP growth in 2001– the third quarter. But in August 2002, significant revisions to the National Income and Product Accounts suddenly showed three consecutive quarters of negative growth in 2001: the first through the third quarters of that year. Was this a revision or a correction?
As we have been predicting, the long-end of the yield curve has started to move up. With the economy gathering momentum, markets have begun to focus on rising demand for funds, as well as higher consumer prices and consequent risks to the outlook. Both the 10 year and the 20 year treasury bonds are up about 80 basis points in the past month. We think this trend will continue. In addition to moderately higher inflation, long-term interest rates will be pushed up by concerns over the bulging twin-deficits. Our long-standing forecasts/warnings of the unsustainable trade deficits as far back as two years ago remain unchanged. We expect the current account deficit to reach 5.4 percent of GDP this year. The fiscal deficit is now projected at $460 billion this fiscal year, or 4.4 percent of GDP, followed by $470 billion in 2004. The combined deficits will reach almost 10 percent of GDP this year. Because of their magnitude, the twin-deficits are expected to drive up the risk premium on treasury bonds, possibly another 50 basis points. And as we have been predicting for some time, the dollar will continue to slide in the face of ever widening trade deficits. We think the Euro could finish this year at US$ 1.28 / Euro.
Latin American Economies
According to official estimates, at the end of 2003 Argentina would have US$23.7 billion in arrears on its foreign debt. Financing needs for 2004 are estimated at US$42.6 billion.
The Bolivian banking system is still burdened by non-performing loans. Credit to the private sector continues to fall, due to much stricter credit conditions and little investment activity. The government announced an extension of the natural gas contract with Brazil to 2029.
Brazil’s Central Bank lowered its benchmark interest rate by 0.5 percent. President Lula Da Silva and the monetary authorities expect a gradual but steady decline of interest rates. Exports were up by 17.8 percent in the first semester of this year.
Preliminary estimates suggest GDP growth of between 3.0 - 3.5 percent in Chile. Best performing sectors include construction, mining and financial services. Consumer spending has also been increasing.
Costa Rica’s economy continues to show signs of improvement. Economic activity was expanding at an estimated 5.2 percent, including Intel, in the first five months of the year, according to the monthly estimator of economic activity. Without Intel, growth reached 3.8 percent, which indicates a widespread expansion. The only laggard has been agriculture, which remains basically stagnant.
Exports from Dominican Republic during the January - April period were growing by 11.7 percent. Free zone exports increased by 13.3 percent.
In Ecuador, president Gutierrez is being hampered by the same lack of political consensus that has hindered previous administrations.
GDP growth for the first quarter in El Salvador was a disappointing 1.7 percent. Construction was the best performer, with a considerable boost from public sector investment in the infrastructure.
Family remittances to Guatemala grew by a record 50 percent in the first six months of the year. For the first time, income from family remittances surpassed that from tourism and exports. Domestic investment will be on the sidelines until after the elections.
Non-traditional exports, especially shrimp, cantaloup, pineapple, mangos, grapefruit, Tilapia, vegetable, cocoa, black pepper and sesame, have been on the rise in Honduras.
Tourist arrivals to Jamaica were up by 19.6 percent up to June. Their expenditures also increased by 14.0 percent.
Industrial output was still contracting in Mexico by 0.5 percent between January and May. Manufacturing was falling by 1.7 percent. On the other hand, construction was growing by 3.8 percent, mining by 2.7 percent and utilities by 2.2 percent.
Economic activity has been weak in Nicaragua during the first quarter. Sagging production has been plaguing agriculture, mining and commerce. There has been a slowdown in manufacturing output and utilities, while a rebound has taken place in the cattle sub-sector, finance and construction.
President Toledo’s weak political image continue to hamper his efforts to further consolidate economic growth in Peru. Beatriz Merino was appointed Prime Minister in an effort to revamp the government’s image. The appointment has been well-received.