We continue to think that the Fed will lower the Fed Funds rate at the next FOMC meeting on June 26. Based on recent declarations by Chairman Greenspan, the Fed is still in an aggressive mood to cut rates. The Fed Funds futures market is trading on a 25 basis point reduction, although we think a cut of 50 basis points is likely. The financial markets are calling for another rate cut of 50 basis points. As we have stated in our earlier briefings, we think the Fed has moved prematurely in terms of the magnitude of the rate cuts since January, and these will likely have inflationary consequences during the second half of this year. In other words, while we are predicting another rate cut, based on the Fed’s viewpoint and policy statements, we do not think the magnitude of the rate cuts have been justified.
The rationale for the additional rate cut is based on what we consider as the Fed’s new focus on market sentiment. The key variables that we use to predict the Fed’s actions are the total return index for the S&P500, the University of Michigan’s consumer sentiment index, the index of manufacturing output, unit labor costs, and the personal savings rate. The stock market index as well as the consumer sentiment and manufacturing production indicators support further rate cuts by the Fed. In addition, financial market participants have been insistent on further rate cuts, or else their clients are going to sell off their market holdings. Seems as if these comments are being taken seriously by the Fed.
Interestingly, Mr. Greenspan continues to think that there is an "absence of inflationary zest," as he stated in his Speech to the New York Economic Club at the end of May. The Fed’s Vice Chairman, Roger Ferguson, told Congress that "I don’t think inflation is going to be a challenge in the short to intermediate term." On the other hand, the Cleveland Fed’s monthly commentary in May stated that households’ inflation expectations rose to 3.7 percent, which is more in line with our own forecast for year end inflation. We think inflation will average 3.6 percent this year, which is a worrisome number, and in sharp contrast with the Fed’s optimistic view of 2.25 percent.
As we have said before, we expect the economy to enter a period of stagflation during the second half of this year. This means that the yield curve will steepen further, and that the Fed may have to undo some of their earlier overly aggressive interest rate cuts. We think the economy was clearly slowing down this year, but not headed into a recession. Our analysis of economic forecasters for the past three years revealed a consistent underestimation of GDP growth, and more recently, an underestimate of inflation. Forecasters have not really understood the growth dynamics of the U.S. economy. Thus we expect the economy to slow, but not stall, since it still has momentum; while the inflation rate will creep up and spook the markets, which have been brainwashed to believe that inflation is no more.
Additional inflationary pressures are brewing in the labor sector. Unit labor costs in the non-farm business sector were up at an annual rate of 3.4 percent during the first quarter of this year, up from 2.3 percent in the fourth quarter of last year. Productivity in the non-farm business sector is slipping fast, which will accentuate cost pressures, and thus lead to increasing prices as producers try to recoup their profit margins.
The revised GDP growth rate for the first quarter of this year was 1.3 percent. Inventories fell sharply, which could result in a pick up in production soon. In fact, if inventories had remained flat, GDP growth would have been 2.1 percent. Consumer purchases of durable goods were up 12.2 percent, helped no doubt by the interest rate cuts. We think consumer spending is going to gather steam this summer from a double bonus. First, lower rates have led to a huge wave of mortgage refinancings, which are usually accompanied by some equity takeouts. Second, the tax cut, which will begin with refund checks during the next several months, has made consumers exuberant about their next shopping escapade. In fact, they are likely to spend their share of the $1.3 trillion tax cut now, rather than wait fo the actual cuts during the next ten years. After all, Congress has developed a new economic theory: first, future surpluses have the same value in today’s dollars; and second, a projected surplus in 10 years is as good as cash in the barrel today. Some readers may recall the famous "down-payment" on the deficit in the 1980s, whereby Congress had approved legislation to reduce the deficit and the down-payment was to be made three years later! If only we could purchase a home and make the down-payment three years after we move in.
Latin American Economies
Argentina successfully completed a swap of short term maturity debt for longer maturity bonds for $29.5 billion. This operation actually constitutes a partial rescheduling of Argentina’s foreign debt. International investors and lenders came to the rescue once again to help avoid a default this year.
A huge natural gas deposit has just been discovered in Bolivia. It has the potential to produce 1.1 million cubic meters of gas, which would make it the highest yielding natural gas deposit in the nation. The IMF and the World Bank added more good news, with the announcement of the pardon of $1.2 billion of Bolivia’s foreign debt, under the auspices of their program for poor countries’ debt reduction. The service of Bolivia’s debt could be reduced by an estimated $120 million in the next 10 years.
Economic activity in Brazil is slowing down, as a result of interest rates hikes and electricity rationing. Investment is slowing and industrial production has been dwindling. The rapid devaluation of the real, pounded by worries about Argentina’s economy, should put upward pressures on inflation.
Chile’s Central Bank lowered interest rates to 3.5 percent in its last revision. The Chilean authorities think that inflation is under control and that this additional cut of 25 basis points will foster a quicker recovery.
The economy continues growing in Colombia, but at a slow pace. Investment is dwindling, due to unstable social and political conditions, while the slowdown in the U.S. economy started to make a dent on exports. For the past two months, Colombia has been swapping short maturity debt for longer maturity bonds.
Costa Rica’s economy is decelerating. Exports have been affected by the slowdown in U.S. demand and low prices for key agricultural commodities.
While layoffs abound in the free zones of Dominican Republic, other investors are betting on the nation’s manufacturing and export potential. The government has issued permits for the establishment of 40 new free zone enterprises this year.
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.
The IMF insists on an increase of the VAT in Guatemala to reduce the fiscal gap. The measure finds tough resistance from practically all sectors of the population. Proposed alternatives, which consist of increasing other taxes, have also been rejected.
Government spending is accelerating in Honduras, as presidential elections approach.
Mexico is experiencing a noticeable 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
The three major political parties have already selected their candidates for Nicaragua’s presidential elections. Daniel Ortega will run again for the FSLN, current Vice President Enrique Bolaņos for the official Liberal Party and Noel Vidaurre for the Conservative Party.
The Panamanian government started implementing an economic reactivation plan, largely along the lines proposed by a committee of notables. However, the employment to be created will mostly be temporary.
Alejandro Toledo finally won the presidency in Peru. APRA candidate Alan Garcia swiftly admitted defeat and promised cooperation. Toledo is now backed by a majority in Congress, after garnering the support of several smaller parties. The composition of his Cabinet is yet to be announced. Financier Pedro Pablo Kuczynski is considered to be a shoo-in for the Ministry of Economy.