March 17, 2003
U.S. EconomyWe do not think the Fed will change the Funds rate at the March 18 FOMC meeting, although there is a significant chance that they would actually lower the rate. The Fed Funds June futures is trading at 1.01 percent, thus betting on another quarter point cut in the rate. As we have said in previous briefings, we think another rate cut will NOT have a noticeable impact on economic activity, but will in turn heighten risks of future inflation and a weaker dollar.
The war in Iraq appears to be imminent, since the options on the table are not acceptable to the US-led coalition, and we appear to be on the verge of the trigger point. A war in Iraq will have a negative impact on the economy during the first year, but beyond a year we are still uncertain as to the final impact. The key linkages between the war and the economy include:
1. Uncertainty about the war and consumer sentiment:
Concerns about a war have hurt consumer confidence, the University of Michigan sentiment index started to decline in January. Consumers are staying away from big ticket items. At the same time, businesses are postponing investment plans pending the outcome of the war.
2. Oil prices:
Oil prices have been rising since November, although the Venezuelan oil workers strike back then contributed to the increase. In February, West Texas Intermediate stood at about $36 per barrel and rising. Higher oil prices will put upward pressures inflation, thus further eroding consumer purchasing power.
3. Cost of the war and the fiscal deficit:
The January Congressional Budget Office forecast for fiscal 2003-2004 calls for a deficit each year of 3.1 percent and 3.4 percent of GDP respectively. With a war, we think this figure could reach a worrisome 5.0 percent of GDP. With the surge in the government’s borrowing requirements, long-term interest rates are bound to start rising.
4. Risk of more conflicts / terrorist threats:
The war in Iraq could spillover into other countries in that region, with further negative impact on oil prices. Terrorist attacks against the US would also add to consumer fears and thus compromise the economic recovery.
The impact of the war also depends critically on the length of the conflict and the political consequences for a post-war Iraq. We think the price tag for the war and the reconstruction of Iraq will be substantially higher than most estimates. US involvement in other hot spots will further drain the government’s fiscal resources.
The war in Iraq will further accentuate the zig-zag pattern of the recovery that we have been describing for some time. The surge in the twin deficits – the fiscal and the external deficits, which may each reach as high as 5.0 percent of GDP, will send the dollar to new lows and the Fed may have to respond in knee-jerk fashion to raise interest rates. The long end of the yield curve is likely to begin its rise after the start of the war. We think there is a possibility of a second recessionary dip triggered by a combination of the war, a surge in oil prices, a falling dollar, and rising interest rates. The housing sector is particularly vulnerable to the latter scenario.
Latin American Economies
We are already seeing the ugly face of inflation in the region, as a consequence of the steep rise in oil prices. Transportation costs, which are usually the first to feel the impact of higher oil prices, are already moving up. The lengthening of the Iraq crisis could threaten the recovery of tourism in the region.
Forced by violent street demonstrations and widespread opposition, Bolivian president Gonzalo Sanchez de Lozada withdrew his controversial 2003 budget proposal. A new budget, to be introduced in Congress, eliminates the tax hikes and the imposition of new taxes. The government hopes to reduce the budget deficit through fiscal downsizing and improvements in tax collections and enforcement.
The Brazilian government promised to introduce fiscal and pension reform laws soon.
The Chilean economy has been gathering strength in the first two months of the year. Industrial production, mining, and electricity have shown a significant improvement, while unemployment edged down. However, the still depressed sales of durable goods are an indication of consumers’ misgivings about the future.
Costa Rica’s economy continues to grow at a moderate pace.
The Dominican Central Bank’s measures to strengthen the currency have managed to stop the peso’s slide. Another contributing factor has been tourism earnings. Tourist arrivals in the first two months of the year posted a record 28.5 percent increase over the previous year. The plush tourism area of La Romana - Bayahibe reports a hotel occupancy rate of 87.3 percent, which compares very favorably to the 60 percent registered in January-February of 2002, although the latter was influenced by the events of 9/11..
Ecuador’s agreement with the IMF, which will be in effect for the next 13 months, calls for a fiscal surplus equivalent to 1 - 2 percent of GDP this year, and the approval of tax, labor, and tariff reforms.
Eleven political parties will take place in the legislative and municipal elections set for March16 in El Salvador.
The Maduro administration will introduce a National Competitiveness Program in Honduras, with the objective of giving a jolt to production and investment.
This is a year of legislative, municipal and state elections in Mexico. These partial elections are usually a gauge of popular satisfaction with the government. Unfortunately for president Fox, they come at a time of economic weakness in the nation.
Panama is gearing up for presidential elections in May 2004. Former president Guillermo Endara will run again for the Partido Solidaridad. The three presidential hopefuls from the official Partido Arnulfista have not been able to garner much popular support. The latest opinion surveys show Endara with 15.6 percent of voter intention, the Arnulfistas trail far behind with less than 10 percent each.
The Peruvian economy continues to recover nicely.