May 15, 2003
U.S. EconomyAs we predicted, the Fed did not change the Funds rate at the May 6 FOMC meeting. We think they will hold the Funds rate at its current level before upward adjustments begin during the second half of the year. We continue to expect the long end of the yield curve to shift up 50 to 75 basis points toward the end of the year, due to improving economic growth and rising inflation.
The FOMC issued an intriguing statement following the May 6th meeting: "Over the next few quarters... the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level." The phrase "unwelcome substantial fall in inflation" can only be interpreted as meaning deflation. Thus the Fed thinks the probability of deflation is significantly higher than the probability of inflation. Interestingly, the University of Michigan’s consumer survey shows that inflation expectations in March were 3.1 percent, up from 2.7 percent in February. Of course, the Fed uses a different index: Personal Consumption Expenditures deflator. Not surprisingly, this index shows a persistently lower rate of inflation historically than the CPI; but that is not all, the Fed takes out food and energy because these commodities are considered too volatile. This is equivalent to a bank restating its net income losses to show significant profits after excluding loan loss provisions and interest expenses, since these items can also be classified as "volatile." As we have explained in previous StratAlerts, the appropriate technique is to use the CPI based on a moving average process. Our trend CPI stood at 2.0 percent in March, and we predict a year average rate of about 3.0 percent for December of this year.
The recovery in this business cycle has been lackluster. As we have explained in the past, every business cycle is unique, and this one will be characterized as the non-recovery expansion. Analysts’ preoccupation with the cookie-cutter model of business cycles can be compared to an economic soap opera which we have titled "Markets in Search of a Recovery." Daily headlines repeat the question: "where is the recovery?" We have had a recovery, but unfortunately it does not fit neatly into the standard model that says the economy usually expands at a brisk rate immediately after a recovery. In previous briefings we have also described the current economic situation as the "zig-zag recovery."
The Wall Street Journal (WSJ) Survey of economists calls for growth to pick up during the second half of this year at a rate of 3.6 percent with lower inflation at year end. It is unusual to project a significant pickup in growth with falling inflation. On the other hand, we think the economy will slow in the third quarter and then pick up again in the fourth and inflation will accelerate moderately during the second half of the year. The early end to the Iraq war and the possibility of lower oil prices (below our forecast range of $24-26 per barrel) could provide some additional impetus. Nevertheless, our GDP growth forecast of 2.6 percent for the fourth quarter 2003 with respect to the same period in 2002, is only modestly lower than the mainstream forecast of 2.8 percent.
With respect to the external deficit and the dollar, our longstanding predictions are being confirmed by recent trends. The trade deficit continues to bulge, and the March figures are consistent with our deficit forecast for this year of 5.1 percent of GDP. As we have mentioned in previous reports, this is the third downward cycle of the dollar, the first was during 1973-78, following the demise of Bretton-Woods; the second was during 1985-87, and was influenced by the Plaza Accord in September 1985; and we think the third downward cycle began at the end of last year. The Euro is up to US$1.14 / Euro, and we had been forecasting a year-end rate of US$1.2 / Euro. We are now raising our year-end forecast to $1.24/ Euro.
As we have explained, the dollar’s depreciation reflects long-standing structural imbalances in the US economy. It is not a temporary blip in the market screen. At the same time, while a depreciation of the dollar will improve the outlook for US exports and reduce demand for imports, we are more concerned about the other side of the coin: the inflationary impact from the fall in the dollar’s value. The US is becoming increasingly dependent on imports of consumer goods, intermediate products, and raw materials. Many goods produced in our economy are made with a significant amount of imported components. This structural imbalance of the US economy will make the dollar vulnerable to adverse external factors. For example, when investors conclude that the dollar is likely to depreciate, they begin to move out their funds from dollars into Euros and other currencies, and thus their views become a self-fulfilling prophesy.
The combination of unsustainable trade deficits, surging fiscal deficits, and a weakening dollar, accompanied by higher inflation, will eventually drive up the risk premium in the long-end of the yield curve, which we expect will happen during the second half of this year. This will also complicate the Fed’s job of managing monetary policy.
Latin American Economies
With public opinion polls showing a surge of support for Nestor Kirchner, just a few days ahead of the second round presidential elections slated for May 18, former president Carlos Menem decided to withdraw from the race and concede the elections to Kirchner. This move, in fact, brings to an end the transitional period in Argentina, which started with the government of provisional president Eduardo Duhalde just after the devaluation debacle. President Kirchner will keep the same economic team, headed by Finance Minister Roberto Lavagna, appointed by his mentor Eduardo Duhalde. Now, with a new democratically elected government, Argentina can concentrate on nursing its battered economy back to health.
The Bolivian economy practically stagnated in the first quarter of 2003. The only sector showing some dynamism was the petrochemical industry. Unemployment and underemployment continue to increase, while according to the Confederation of Private Enterprises, 9 out of 10 Bolivian firms are facing serious difficulties.
The IMF recently completed a review of Brazil’s economic program for last year and found that Brazil has successfully complied with all its targets. The Brazilian government is now aiming for a primary budget surplus of 4.25 percent of PIB for 2003, instead of the originally planned 3.25 percent.
The Chilean Central Bank kept the key short-term interest rate at 2.75 percent. Some inflationary pressures have been building up lately. The authorities hope that lower oil prices and a stronger currency would help put a lid on inflation.
The Colombian government is expecting GDP growth of around 3.0 percent in the first quarter, led by energy, construction and industrial production.
Costa Rican exports soared by 23.1 percent in the first quarter of this year. Agricultural exports increased by 22.0 percent, textiles by 11.0 percent and free zone exports (weighted heavily by the Intel micro-processor assembly facility) by 39.2 percent.
Dominican Republic’s exports in the first quarter of 2003 expanded by 18.0 percent, boosted by 15.5 percent growth in free zone exports. The Central Bank’s decision to pay all obligations of the recently intervened bank has calmed the markets.
El Salvador has not yet published preliminary figures for the first quarter. However, the authorities anticipate moderate growth, spearheaded by electricity, construction and commerce.The Central Bank of Jamaica is struggling to contain the slide of the Jamaican dollar, which has been hovering around J$60/US$ and has at times surpassed that historical mark.
Mexico will announce its third quarter GDP estimates on May 15. Early estimates suggest GDP growth of about 2.7 percent. Family remittances increased substantially by 26 percent during the first quarter of this year with respect to same period in 2002. The first quarter of the year is usually the weakest for family remittances. This strong performances raises the possibility that remittances will break the US$10 billion mark by the end of the year.Construction has yet to rebound in Nicaragua, after the completion of damage repairs from Hurricane Mitch. Private construction has been hampered by political uncertainty.
Panama’s GDP grew by an estimated 1.7 percent in February. Expectations are that economic activity could grow by about 2.0 percent in the first quarter. However, growth has been uneven. Fishing and construction are expanding at a brisk pace, while agriculture remains depressed.
Nicanor Duarte has been elected president of Paraguay. His economic team, which counts with the blessings of the business community, will be comprised mostly by officials of the former administration of Luis Gonzalez Macchi.
Peru is in the final stage of its negotiations for a free trade agreement with Brazil. The pact will be signed in August by the presidents of both countries.
Venezuela’s foreign exchange controls instituted since February are already causing production bottlenecks and disrupting the supply of goods, as its predecessor RECADI did in the 1980s. An opinion poll conducted in April showed widespread rejection of president Chavez. About 60 percent of all registered voters are likely to vote in the August referendum, if the government allows it. Of that number, 60 percent will vote for the revocation of Chavez’ mandate.