November 28, 2006
U.S. Economy
We expect the Fed to maintain the Funds rate at 5.25 percent at their next FOMC meeting on December 12. While the economy is slowing down, as the Fed anticipated in its previous FOMC statements, there is rising concern about inflation. In fact, several Governors and regional Fed Presidents are signaling that inflation is on the high side. One Fed official feels that the Fed may have kept interest rates too low for too long considering recent data showing that the PCE deflator underestimated inflation. Hopefully, the recent correction to the PCE deflator will serve as a valuable lesson: that it is much better to stick to one price index, such as the CPI, with its limitations, than to manufacture an index for each business cycle in order to reach the lowest reading on the inflation gauge. As we have mentioned in previous StratAlerts, the PCE deflator historically lags the CPI measure of inflation, thus when the PCE deflator measure of inflation – excluding food and energy, begins to exceed the CPI measure, we expect the Fed will then announce that the PCE inflation measure is no longer a credible index, and they will most likely return to guiding their policy decisions by the CPI.
We think Mr. B has implemented a very open management style at the Fed, with Fed Governors and regional Presidents expressing their views more openly, and in plain language – no riddles!
The economy continues to slow, but still retains some positive momentum. Third quarter GDP growth was 1.6 percent. Nevertheless, industrial production has kept on humming, averaging a 12 month growth rate of 5.0 percent during June - October. The slowdown has been accentuated by the drop in residential investment which fell at an annual rate of 11.1 percent and 17.4 percent during the second and third quarters. This was offset by growth of consumer spending which expanded by 3.1 percent in the third quarter, with expenditures on durable goods up 8.4 percent. Business fixed investment was also up 8.6 percent in the third quarter.
We think the economy will continue to lose steam during 2007. The sharp cutback in construction spending will have spillover effects on other sectors such as building materials and home furnishings. Nevertheless, consumer spending should help sustain the expansion. While real estate prices have fallen, we think there is still enough equity in exiting homes to fund more spending. The key question is when will consumers reach an uncomfortably high level of debt which will happen long before they can cash out their available home equity value. We think the persistent rise in the ratio of household debt to disposable income rather than the decline in home values will signal weaker consumer spending next year. On the other hand, the debt service payments ratio has not reached a worrisome level thanks to historically low interest rates. We expect the economy to average GDP growth of 3.3 percent this year followed by a slowdown to 2.7 percent in 2007.
Recent comments by analysts regarding inflation have led us to conclude that when inflation declines – due to a drop in oil prices, analysts point to the decline in the CPI, but when it increases, they say not to look at the CPI, but look instead at the PCE deflator ex food and energy! As we explained in a previous StratAlerts, this seems to be a new theory that we have dubbed the "kinked" inflation curve.
We think lower oil prices and weaker construction activity, which have begun to drive down building costs, should help moderate inflationary pressures in 2007. Nevertheless, the trend is not encouraging. We expect the 12 month inflation rate to slow from 4.3 percent in June of this year to 3.3 percent in December, before picking up again to 4.0 percent towards the end of 2007.
As we have been predicting for some time, the continued hemorrhaging on the external accounts combined with a weaker U.S. economy are now pushing up the value of the Euro. This will add a new twist to the Fed’s monetary policy platform. Fortunately the continued strength of the economy has kept the Federal budget deficit within manageable proportions, at least the cash deficit.
The interest rate conundrum continues to perplex the best analysts such as those at the Fed. Based on our expectation of persistent inflationary pressures, even with a slowing economy, we think the long-end will move up during the first quarter of 2007 sufficiently to regain the normal positive slope of the yield curve.
Latin American Economies
Argentina
- this will be another banner year. Argentina is poised once again to be among the fastest growing economies in Latin America. The authorities are worried about inflation, but will keep relying on price control agreements with the producers for at least one more year.Bolivia
- the government and the opposition are locking horns about voting rules in the Constitutional Assembly and two controversial laws approved by the government-controlled House of Representatives, but opposed by the opposition-controlled Senate. An agrarian reform law would give ample confiscatory powers to the government. Another law authorizes the removal of elected provincial governments for "misconduct". President Morales instigated a popular march on La Paz in order to force the Senate into approving the two pieces of legislation. The opposition senators then decided to retreat to their regions, paralyzing the Senate. Six out of nine provincial governors strongly oppose the law that would allow their dismissal by the president. Opposition groups in several provinces are threatening with countermarches and road blockades. In the midst of the worst crisis during his term in office, president Evo Morales leaves the country for a five-day trip overseas. Negotiations to resolve the issues are now in the hands of vice-president Alvaro Garcia Linera, who also resolved a delicate issue with Brazil a few weeks ago, regarding Petrobras investments in Bolivia.Brazil
- President Luiz Inacio "Lula" Da Silva comfortably won the second round presidential elections. He now wants to set a goal for the economy of 5.0 percent annual growth during his second term in order to create more jobs.Costa Rica
- high-technology, agricultural and medical equipment exports are showing a significant expansion. Construction is booming, propelled by residential, commercial and hotel development. Direct foreign investment could top US$1.0 billion for the first time in history.Dominican Republic
- the economy has been growing by 11.3 percent up to September of this year. Growth of 10 percent in the third quarter marks the fifth consecutive double-digit quarterly growth.Ecuador
- Leftist Rafael Correa has won the presidency in the second round by a wide margin over Alvaro Noboa. Official results will be announced this week. Correa is an economist without previous political experience, except for a stint as Minister of Finance, and has publicly flaunted his friendship with Hugo Chavez. In his first declarations after the elections he has pledged to support the dollarization and to renegotiate the external debt, while definitely nixing negotiations for a free trade agreement with the U.S.Honduras
- assembly exports and construction are leading to way to an estimated GDP growth of 5.8 percent this year. Assembly activity could reach a 30 percent growth over the previous year. Workers’ remittances have also made a substantial contribution to the economic expansion.Mexico
- President-elect Felipe Calderon, has announced his economic and social cabinet members. Agustin Carstens, a highly respected economist, who has been recently with the IMF will be the new Finance Minister. Saying that he is the "legitimate" president of Mexico, defeated candidate Manuel Lopez Obrador staged a symbolic inauguration ceremony at El Zocalo, promising to lead a shadow government. His followers are bent on disrupting the inauguration of Felipe Calderon. Opinion polls consistently indicate loss of popular support for Lopez Obrador and his antics.Nicaragua
- Daniel Ortega won the presidential elections with less than 40 percent of the votes, avoiding a run-off thanks to his previous agreement with the incarcerated former president Arnoldo Aleman. Their agreement allowed for the passage of a law that permits a victory in the presidential elections with just 35 percent of the votes and a margin of at least 5 percent over the closest opponent.Uruguay
- the bitter dispute between with Argentina over the cellulose plant to be built in Uruguayan territory across the river from Argentina keeps boiling. After extensive studies, the World Bank does not see any damage to the environment, as claimed by Argentina and has authorized funding for the plants. The Argentine government has refused to break up the blockade of roads leading to Uruguay. The dispute has not been resolved within Mercosur and now Uruguay will take the issue to the International Court at the Hague.Venezuela
- presidential elections will be held on the first Sunday of December. Opposition candidate Manuel Rosales has been campaigning tirelessly, speaking to impressive throngs. However, we think that the results of the elections will give the victory to Hugo Chavez, who vows to stay in power until at least 2021.