Latin American Economies Argentina’s new finance czar, Mr. Cavallo, has been basically prescribing the same recipe as his predecessors in the Finance Ministry, more borrowing. The agreement recently reached with the IMF is a mere re-accommodation of the performance targets for the Argentine government. The economy remains stalled and social tensions are rising.Yesterday, the Fed lowered the Fed Funds rate by 50 basis points to 4.00 percent and the Discount Rate to 3.50 percent. Since January 3 of this year, the Fed has lowered the Funds rate by 250 basis points. The markets responded with expectations of further rate cuts, the Fed Funds August futures are now trading at about 3.75 percent.We think the Fed will lower the Funds rate at least another 50 basis points within the next 90 days, but we are very concerned that this will contribute to higher inflation in the second half of this year, without really having an impact on real output growth. We base our expected rate cuts on previous aggressive Fed actions and their insistence on averting any further economic slowdowns.
As we have explained in previous StratAlerts, the Fed’s recent actions imply a shift from targeting the money supply to targeting the value of equities. This is based on the repeated statements by the Fed regarding their concerns about consumer sentiment and a possible "irrational" collapse of consumer spending if the equity markets falter. Thus, our prediction of further rate cuts is derived from the pattern of the Fed’s recent policy actions and their response to the following key indicators: first, the S&P500 all return index; second, the University of Michigan’s consumer sentiment index; and third, the personal savings rate. In view of the steep declines in the S&P500 earlier this year, we predict the Fed will continue to reduce interest rates. If the S&P500 index were to return to a historical rate of return of about 14 percent per annum, measured on a five year basis, then another 10 to 15 percent decline would be called for. Such a drop in equity prices would justify another 50 basis point cut by the Fed.
With respect to the consumer sentiment index, in April it was already down to 88.4 from 107.6 last November. The decline in this index also favors another significant rate cut by the Fed. Finally, the personal savings rate has been negative since last July, this is the first time savings is negative going back to the start of the data series in the 1950's. A negative savings rate would imply caution in terms of rate cuts; however, the weight of the other two variables from the Fed’s perspective is much greater, and thus we conclude that another 50 basis points cut in rates is likely.
The principal risks to the Fed’s aggressive interest rate cuts are higher inflation and a greater dis-savings (higher negative savings rate), which will further aggravate our external deficit problem. First of all, where is the recession? In January, the Fed asserted that the economy had been in a recession in the fourth quarter of last year; then in his February testimony, Mr. Greenspan stated that the economy was also in a recession during the first quarter of this year. Yet the data seem to contradict this, GDP expanded by 1.0 percent in the fourth quarter, and the preliminary first quarter figure shows a healthy 2.0 percent rate. Personal consumption expenditures were up 2.8 percent and 3.1 percent during the fourth quarter of last year and first quarter of this year, clearly consumers are not thinking recession yet. We recognize that industrial output has been declining, 2.8 percent since last October, but as the Fed has stated, this is likely an inventory adjustment. We think the economy was never headed into a recession, but rather slowing to a more manageable rate. If our view proves correct, then the recent aggressive rate cuts could backfire in the form of higher inflation later this year. This would result in what we have been referring in our previous StratAlerts as stagflation, followed by possible recession in 2002.
The Fed’s view is that inflation is "expected to remain contained," but we differ significantly on this issue. Inflation has been gathering steam during the past year. Since the "core" inflation rate is a misleading indicator, we use a moving average of the consumer price index. The April inflation rate of 0.3 percent puts the moving average rate at 3.4 percent, and we think this will rise to about 4.0 percent during the second half of this year.
Another risk to the aggressive rate cuts is further declines in the personal savings rate. During the first quarter of this year, the savings rate averaged negative 1.0 percent (dis-savings). Based on our expectation of higher inflation during the second half of this year, and another 50 basis points cut in the Fed Funds rate, we could see marginal or zero real short-term interest rates. Further interest rate cuts will simply encourage more spending, which will lead to a higher negative savings rate, and possibly greater risks associated with consumer debt. We think this will also contribute to a widening of the already worrisome trade deficit. The U.S. current account deficit last year was about 4.5 percent of GDP, clearly an unsustainable level. The Asian and the Mexican crises were triggered by large external deficits. In the case of the U.S., the dollar could suffer a serious beating in the currency markets as the deficit continues to widen, which would then add to inflationary pressures and result in higher interest rates.
We base our higher inflation outlook on two factors: first, the increase in liquidity triggered by the Fed’s interest rate cuts; and second, the slowdown in productivity, which will result in higher production costs. With respect to the second factor, there are already indications of rising unit labor costs (ULC). Non-farm businesses have reported an increase in ULC of 3.1 percent during the past year, in contrast to an average of 1.8 percent during the past five years. Productivity is an essential component of rising production costs. Mr. Greenspan has made repeated references to extraordinary innovations during the past several years, which have contributed to sizeable growth in productivity. This is particularly the case for private manufacturing, where output per worker has grown by 4.3 percent during the past five years. However, this is only a partial indicator. A better measure of productivity is what is called the multi factor productivity, which includes labor, capital and other inputs. This index has grown by only 2.4 percent per annum during the same five year period. The lower growth of multi-factor productivity could be explained by the fact that businesses have to use more capital to produce their output. At the same time, labor productivity in the non-farm business sector has not been as robust, averaging an unimpressive 2.7 percent per annum rate. We think productivity growth will remain flat for the remainder of this year, thus contributing to rising ULC’s.
Finally, some comments on the recently announced House agreement on a $1.35 trillion 11 year tax-cut package. This figure is misleading, since it is based on future values. In order to assess the importance of this reduction in taxes we need to know its PRESENT VALUE, which we think is substantially lower. Nevertheless, as we have said in the past, we applaud any efforts to eliminate the surplus by returning hard earned tax dollars to consumers. The role of the government is to balance the budget, not to run surpluses. We also think the government should abstain from endless debates on 10 year projections, and focus more on the short- to medium-term budget package. Long-term planning is important, but it should not become a time-consuming public debate spectacle. We agree with the Administration’s view that part of the Social Security system should be privatized. Many countries have done it. Interestingly, the Social Security surplus creates an incentive for running deficits, since all of the Social Security surplus has to be invested in low yielding U.S. government notes and bonds. We also strongly recommend NOT to pay down the national debt. The opportunity cost of money for taxpayers is much higher than the low interest rates the government pays on its debt.
Mineral exports fell by 21 percent in Bolivia, during the first quarter of the year, as a result of lower mineral prices in the international markets.
Brazil faces the possibility of electricity rationing, starting in June. Water levels in the reservoirs used for hydroelectric production have fallen significantly, due to a severe drought. The government is trying to cut electricity consumption by 20 percent, but if the drought persists, cuts could climb to 35 percent. In any case, the energy rationing will have an impact on GDP growth rates this year. Chile’s Central Bank maintained interest rates at 3.75 percent in its last revision. We think that the Central Bank is through with interest rates reductions. The present climate of currency volatility requires greater prudenceEconomic prospects are looking up in Colombia. After being in a deep recession since 1995, the construction sector registered excellent growth of 35.8 percent in the first quarter of 2001. Industrial production also grew by 4.6 percent, during that period. The convulsed social and political situation continues to be Colombia’s greatest drawback.
Costa Rica’s exports plummeted by 24.0 percent in the first quarter of 2001, due to sagging U.S. demand. Intel exports fell by 57 percent, while textile exports to the U.S. market declined 22 percent. In addition to that, coffee and banana exports continue depressed.The effect of the slowdown in the U.S. is also affecting Dominican Republic. Activity has decelerated markedly in the free zones, where many employees have been laid-off. Retail sales are already feeling the pinch. There is a strong possibility of lower family remittances from Dominicans working in U.S.
Economic activity is starting to improve in Ecuador. Consumer spending is finally recovering, due to the significant contribution from family remittances from Ecuadorians living overseas. However, inflation remains high at about 46.6 percent
Family remittances to El Salvador continue to grow at a strong pace, which has a beneficial impact on the local economy. Increased remittances are also a response to the recent earthquakes. Reconstruction from the damages caused by the earthquakes should boost economic activity in the second half of the year.
After flirting with the possibility of dollarization, Guatemala has finally discarded the idea. Economic activity has been receding in the first quarter of the year, while dissatisfaction with the government grows.
Social calm returned to Honduras, after Ricardo Maduro was certified as a legitimate candidate for the presidency. The government ditched the privatization program, citing lack of investors’ interest in Hondutel. The authorities are likely to refrain from taking crucial measures so close to the presidential elections.
Mexico is experiencing a sharp economic slowdown, as a result of lower U.S. demand and a drop in oil income. Oil production was cut in line with OPEC’s reductions and crude prices have eased somewhat from last year’s highs. In response to diminishing revenues, the Fox administration announced spending cuts, mainly on infrastructure improvement, agricultural and electricity programs Nicaragua will shortly start adjusting Customs merchandise valuation, in compliance with OTC requirements.The Panamanian government backtracked on its proposed increase in transportation fares, after violent street demonstrations. The hike was officially postponed until December.
In Peru, Alejandro Toledo keeps ahead of former president Alan Garcia, in their quest for victory in the second round of the presidential elections, set for June 3. However, the electoral climate has been marred by a blank vote campaign, promoted by journalists Jaime Bayly and Alvaro Vargas Llosa. The journalists have made morally damaging allegations against Toledo, while maintaining that Alan Garcia is also unfit for the presidency. Since the campaign started, about 30 percent of voters have stated their intention to deliver a blank vote in protest.