As we had predicted, the Fed lowered the Fed Funds rate by 25 basis points at the FOMC meeting on June 26. While we had expected a 50 basis point cut, it seems that Mr. Greenspan is encountering resistance from other Committee members concerned about the potential for greater inflation. At last, someone shares our concern over inflationary pressures. The Fed Funds futures is sitting on the sidelines without a call for the rate to move one way or the other. We think another 25 basis points is consistent with the Fed’s view that market sentiment should guide monetary policy. After all, Wall Street has been very persuasive in threatening the Fed with a massive sell-off of securities if they do not lower interest rates. Since January of this year, the Fed Funds rate has been cut from 6.60 percent to 3.75 percent. The Fed’s view of inflation remains unflinching: there is no inflation, the current statistics showing 3.5 percent is a figment of our imagination.
The Wall Street Journal’s "Blue Chip" economic forecasters are calling for a benign storybook scenario of economic growth with lower inflation. The forecasters are calling for GDP growth of 2.7 percent in the fourth quarter of this year, followed by 3.1 percent in 2002. According to their prediction, inflation should fall to 2.9 percent in the fourth quarter of this year. Interestingly, half (27 of the 54) economists in the survey represent financial institutions, who have a vested interest in a happy ending to this economic story. We hold a significantly different view of the economic outlook, which is more in line with the traditional business cycle theory, and we also consider that the Fed overshot the reduction in interest rates.
We think the economy will post 2 to 2.25 percent growth during the second half of this year, accompanied by relatively high inflation of 3.5 percent, based on the year average CPI, and 3.8 percent December / December. With such high inflation numbers, the Fed may have to do a 180 degree turn from expansionist to restrictive monetary policy.
Based on our inflation rate forecast of 3.5 percent for this year, and assuming a real interest rate on the low side of 3.0 to 3.5 percent, the 10 to 20 year bonds should be 6.5 to 7.0 percent. Thus our view is that medium to long-term rates are headed up.
The latest revision of GDP growth for the first quarter of this year was 1.2 percent. Inventories fell sharply, but more interestingly, consumer spending jumped by 3.4 percent, up from 2.8 percent for the fourth quarter of last year. We do agree with the Fed’s concern over the industrial sector, which has been cutting output during the past seven months. However, based on Mr. Greenspan’s testimony, the reduction in industrial output is basically an inventory adjustment; thus growth in this sector should resume in the near term.
Consumers will continue to spend, thus giving businesses some opportunities to improve margins and to counteract slower productivity growth. Consumer debt service ratio is up to 7.8 percent. The latest double bonus: lower interest rates and the tax rebate should encourage more spending.
Latin American Economies
By setting a special foreign exchange rate, tied to a mini-basket composed of 50% euro and 50% U.S.$, Argentina de facto devalued the peso. The "Canastilla Cavallo" is a badly designed copy of the ECU. It is the first step in a generalized devaluation. The economic crisis is far from over and doubts persist about Argentina’s capacity to service its foreign debt. Additional fiscal tightening and the government’s inability to foster economic growth are heightening social tensions. The so-called debt swap was actually a rescheduling forced upon domestic debt holders of Bonods and Bocons.
Bolivia’s natural gas is now in high demand. Negotiations are in progress to sell natural gas to the U.S. and for additional shipments to Brazil. Construction on a new gas pipeline to Argentina will start this year. Bolivia is also negotiating a reduction of its bilateral debt with the Paris Club. The health of president Hugo Banzer is now a cause of concern.
Economic activity in Brazil is slowing down, as a result of interest rates hikes and electricity rationing, after a strong performance in the first quarter of this year. The trade balance has deteriorated in the first four months of 2001, due to a combination of diminishing exports to Argentina and higher imports of oil and fuel.
Chile is in better shape than the rest of the Latin American nations, despite below potential growth this year. A moderate improvement in copper prices could bolster the external accounts.
Costa Rica is officially in recession after two consecutive quarters of economic contraction. Economic activity has been hard hit by the slowing U.S. economy. Agriculture, manufacturing and commerce are depressed. About 2,600 jobs have been lost in the banana sector and 2,000 in the textile sector. However, construction and tourism retain their dynamism.
Dominican Republic is also feeling the impact of slow growth in the U.S, although free zone manufacturing and exports are still churning along. GDP growth fell by 1.5 percent in the first quarter. Domestic demand is sagging. Agricultural production fell by 3.4 percent, manufacturing by 5.6 percent, construction by 7.2 percent and commerce by 7.6 percent. Tourism keeps providing some impetus and family remittances remain strong.Inflation has been subsiding in Ecuador, although it is still very high at close to 40 percent. Interest rates have been sliding down, which will bolster investment. After much deliberation, an IVA increase from 12 percent to 14 percent, was finally approved. The strong currency has contributed to a surge of 63 percent in imports, while exports receded by 7.0 percent during January-April. Construction of a new oil pipeline and higher foreign investment are also boosting imports of capital goods.
El Salvador managed to grow by 1.7 percent in the first quarter. Agriculture and commerce were basically flat, but construction activity expanded by 8.8 percent. We expect construction to spearhead economic activity this year.
Stormy social and political weather has afflicted Guatemala, after the government formally introduced a tax increase package to Congress for approval. The most staunchly opposed measure is an increase in the VAT from 10 percent to 12 percent. Workers, students and the business community are united in the rejection of tax increases. Street protests are being staged across the country and there are plans for a general strike. 15 legislators from the official party, FRG, are threatening to leave the party over this issue. In that case, the FRG will lose control of the legislature.
Honduras’ trade balance has been deteriorating in the first four months of the year, due to a depressed market for coffee and higher imports of oil.
Financier Pedro Pablo Kuczynski has been officially appointed as Economy Minister by Peru’s president-elect Alejandro Toledo. The announcement has been very well received by the international financial community. Mr. Toledo has been slow in announcing the composition of his Cabinet.