March 29, 2005
U.S. EconomyAt its March 22 meeting, the FOMC voted to raise the Funds rate another quarter point to 2.75 percent and then issued the by now familiar but still not well understood statement "with underlying inflation expected to be contained... policy accommodation can be removed at a pace that is likely to be measured." Earlier in the statement, reference was also made to pricing power becoming more evident. As we have stated in the past, we think there are many hands in this kettle. Unfortunately, some analysts are much more concerned about what it is they think the Fed is trying to say with these dysfunctional riddles, without realizing that deep down, the Fed, as a Central Banker, knows that they can never really say what they mean. So our recommendation for Fed watching is stick to basic economic data and to the record of the Fed’s own actions – as in 25 basis points per meeting, for hints as to what is likely to happen.
Economic activity is expanding at a faster pace than expected. Fourth quarter GDP growth was revised up to 3.8 percent, thus the economy expanded by 4.4 percent in 2004 following 3.0 percent in 2003, not a bad performance for a recovery. The WSJ survey of economists calls for robust GDP growth of 3.9 percent this year, compared to our forecast of 3.5 percent. Industrial production has been gathering momentum as shown by our moving average trend growth of 4.3 percent as of February. While consumer debt continues to rise, increasing net worth, driven by the real estate value frenzy, has kept the banks’ lending pipeline flowing and thus consumer spending growing, particularly in durable-goods. Low mortgage rates continue to fuel housing construction.
Inflationary pressures, as we have predicted consistently for some time, are moderately gathering momentum. Oil prices are testing new highs and the long-hot summer with rising gas prices is just around the corner. Our 12-month moving average measure of CPI inflation is running at 2.9 percent, and we predict that the rate will reach 3.1 percent by year end. Stronger than expected economic growth could put further upward pressures on prices. The University of Michigan’s consumer survey shows inflation expectations of 2.9 percent.
Higher growth, inflation and a much weaker dollar are in our view the key short-term concerns, rather than the fiscal deficit as a recent survey of business economists concluded. While the fiscal deficit is high, it is still manageable, and the structural fiscal deficit problems will not hit us for about another four to five years. In other words, we DO think the fiscal deficit matters, but a fiscal deficit of $430 billion when this year’s trade deficit is likely to hit $780 billion in our humble view does NOT matter in the short run, when compared to the risks associated with a rising inflation rate fueled by a robust economy and a falling dollar. Thus interest rates will continue on an upward path. The Funds rate should end the year at 3.75 - 4.00 percent. The long end of the yield curve will also move up, reaching 5.75 percent for the ten year and 6.25 percent for the 20 year bonds.
The Arrogance of the Dollar
The Chairman of the Fed, who in the absence of any other visible spokesman for economic policy, has been asked to opine on every economic issue outside of monetary policy, and has taken balance of payments analysis for a ride. The Fed Chairman has stated emphatically that in a global economy external imbalances are not disruptive and that markets resolve the imbalances smoothly. In fact he has claimed repeatedly that predicting the value of the dollar is no different than tossing a coin. With the utmost respect, we would appreciate the opportunity to ask the members of the FOMC whether they too toss a coin when they meet around the table to determine which way medium- and long-term interest rates are headed among other variable they predict in arriving at their monetary policy decisions.
In discounting the relevance of the dollar as a policy concern, the Fed Chairman has cited two, logically supportive, Fed studies which conclude that among developed countries external deficits do not result in disruptive economic adjustments, that is something that usually occurs among emerging markets. This was the conclusion of the study: "Financial Market Developments and Economic Activity (February 2005)." However, we do not agree with the approach taken by the study. The group of Developed Nations selected for the analysis is a motley crew with a wide range of economic issues. The flaw with the analysis is not having been more selective in the control group. The average current account deficit prior to currency adjustments for the group was 3.9 percent of GDP. If we classify the U.S. in the group of "high" deficit countries, as in greater than 6.0 percent of GDP, then the countries in that sub-group were shown to exhibit significant disruption of GDP growth as a result of the adjustment in their external accounts. The study goes on to say that the U.S. already experienced currency adjustments as a result of external deficits, mainly during 1985-1987, but it failed to indicate that in 1985, when the dollar started to take a tumble, the deficit had peaked at only 3.0 percent of GDP.
Being the largest money market currency in the world can create sizeable aftershocks in the financial markets following an abrupt adjustment in its value. Based on our earlier forecasts of a year-end or sooner rate of US$1.55 / Euro, we are definitely anticipating a not so smooth ending to this episode of current account adjustments, with unpleasant consequences for inflation and interest rates. As we have explained in previous
StratAlerts, the rising value of the Euro is triggered by over-shooting in the currency markets. Since the U.S. trade deficits continue to worsen as the dollar falls in value, it will take a much bigger drop in the value of the dollar to finally trigger a reduction in the U.S. over-dependence on imports. The trade deficit is driven by excess demand in the U.S. as well as structural economic imbalances that we are just beginning to discover, and it will thus take a much greater currency value adjustment to cool off that excess demand. Short-term capital flows are usually the drivers of change in currency values. For example, foreign investors temporarily withdraw their investments from the U.S., i.e. sell U.S. Treasury bonds, which triggers a depreciation of the dollar, and place those funds in another currency, and then they reinvest those funds back in the U.S. after the expected currency rate change has occurred. Once a sustainable adjustment in terms of lower current account deficits has taken place, the value of the dollar would move up again, but only after U.S. consumers have paid the bill for their earlier spending spree.Of course, we are among a very small and uninfluential group of economists that have persistently warned of the U.S. external imbalance, but who can at least profit from our views. On the other hand, there is always the possibility that the Fed’s next study will recommend a new measure of "core-GDP," which obviously excludes the external accounts, since they are not relevant for monetary policy and in a global economy do not really matter.
Latin American EconomiesThe
Argentine government announced that 76 percent of bondholders had accepted the terms of the proposed swap to make it official. The government will essentially restructure its original US$81.8 billion debt by issuing new instruments valued at US$35.3 billion, this represents an average reduction of 43 percent in the face value of the bonds.The serious social and political crisis engulfing
Bolivia has prompted President Carlos Mesa to twice threaten with resignation. President Mesa has also proposed to move up the presidential elections slated for 2006 to the summer of 2005, but the Assembly has refused.The
Brazilian government officially announced that Brazil will not renew its Stand-by Program with the IMF, which expires on March 31.Former
Chilean defense minister, Michelle Bachelet from the Socialist Party, is poised to win the government coalition primary set for next July.Family remittances to
Colombia reached US$3.9 billion in 2004, surpassing the total value of agricultural exports. By 2005, family remittances are expected to represent about 3.7 percent of GDP.Honduras
expects to receive close to US$200 million this year from several U.S. NGOs, mainly for infrastructure improvement.After a strong fourth quarter in 2004, construction and manufacturing kept their strength in January 2005 in
Mexico, except for vehicle production.Preliminary estimates for 2004 indicate that GDP grew of 5.1 percent in
Nicaragua accompanied by a 25 percent increase in exports.2004 Foreign Direct Investment in the Region.
The Economic Commission for Latin America and the Caribbean (ECLAC) recently announced that foreign direct investment in the region rose to US$56.4 billion in 2004, equivalent to a 44 percent increase over the US$39.1 billion registered in 2003. That is good news. However, inflows of US$56.4 billion are still well below the annual average of US$70.6 billion during 1996-2000. China and the Asian economies now attract greater foreign investment flows than Latin America.
In 2004, Brazil was the main recipient of foreign investment in the region with US$18.2 billion, followed by Mexico with US$16.6 billion and Chile with US$7.6 billion. Mexico and the Caribbean Basin (including Central America) attracted US$22.3 billion, Mercosur US$20.3 billion and the Andean Community US$6.2 billion. Foreign direct investment increased for all Latin American and Caribbean countries, except Panama and Venezuela, whose inflows fell by 41 percent and 57 percent respectively.
About 51 percent of total foreign direct investment went to services, 36 percent to manufacturing and 13 percent to the primary sector. However, investment in high technology industries was very low.