The horrendous September 11 terrorist attack on the US has had a detrimental impact on the economy. The anxieties associated with the pending threat of another attack and the US military response against the terrorists has depressed consumer confidence. In view of the already weakened state of the economy, this latest crisis will precipitate a recession.
The Fed’s decision to lower the Fed Funds by 50 basis points on September 17 was aimed at bolstering confidence. This was in line with the Fed’s strategy since the end of last year to use monetary policy to sway market sentiment. At the same time, the Fed pumped a huge amount of liquidity into the system following the terrorist attack in order to support the payments system. The decision by the European Central Bank to follow the Fed and to cut their interest rates by 50 basis points was very encouraging news. This is probably the first time, since the Plaza Accord in 1985, when the Group of Seven acted in close coordination. It is also a clear sign of allied support for the US.
Fed officials acknowledge that their policy decisions are hindered by lack of information. In a recent speech, Mr. Greenspan stated that the Fed needs more reliable information on the behavior of the components of consumer wealth such as equity values and real estate prices. He also mentioned that the recent rise in home prices amid the fall in equity prices has made calibration of Fed policies more difficult. At the same time, at least one member of the FOMC is concerned with the inflationary impact of further rate cuts.
A slowing economy, and now recession, has led to calls for additional tax rebates. We think the focus of fiscal stimulus will now be on the reconstruction of New York City and on strengthening national security. Additional infrastructure investments geared to job creation next year is also likely.
Regarding the projected 10 year surplus, the government needs to focus its fiscal debate on the next three to four years, and stop releasing embarrassing ten-year budget forecasts. Budget discussions prior to the terrorist attack were also creating confusion. References to the government having to tap into the Social Security surplus were misleading statements. By law, the Social Security is required to invest its surplus in US government securities. Perhaps politicians were just alluding to the expected Federal budget deficit, excluding the Social Security surplus, but their terminology was confusing. On the other hand, this discussion raises the interesting point, that with privatization of the Social Security, contributors would be able to determine how to invest their funds.
Inflationary pressures have subsided modestly. Based on the August 0.1 percent increase in the CPI, we now expect inflation for this year to average 3.1 percent, down from our earlier 3.4 percent figure. The recent slowdown in productivity growth could result in renewed inflationary pressures. Higher oil prices are also expected to keep the inflation rate at its current level.
A stubborn inflation rate has resulted in an upward sloping yield curve. Based on a projected inflation rate of 3.0 percent, the 20 year treasury bond could begin to move up during the next several months.
The revised second quarter GDP growth of 0.2 percent underscores the weakness of the economy, which after the events of September 11, is considered to have slipped into a recession. Fortunately, consumer expenditures continued to expand in the second quarter with 2.5 percent growth. The Fed’s interest rate cut and the tax refund have helped in that regard. Business investment dropped noticeably in the second quarter, down 10 percent. Inventories also fell significantly for a second consecutive quarter.
The external sector continues to pose a significant risk to this outlook. We have for some time been concerned about an unsustainable trade deficit. Even with the slowdown in the US economy this year, the trade deficit has only nudged down to 4.4 percent of GDP, from 4.7 percent last year. The terrorist attack on the US could harm the dollar’s image as a safe haven, and lead to some retrenchment by foreign investors, thus undermining the value of the dollar. A falling dollar would further complicate the management of monetary policy, and possibly compel the Fed to raise interest rates.
Latin American Economies
Recession in the U.S. will result in marginal growth for Latin American economies in the 2001-1002 period, less than one percent, since this unfortunate development came at a time of already weak economic activity in the region. The areas of greatest concern are tourism, exports and family remittances.
With reluctant U.S. support, the IMF put together another rescue package for Argentina, this time for $8.0 billion. IMF officials have declared that these funds could still fall short of Argentina’s financial needs. As we have repeated in the past, this will only aggravate their external debt problems.
Bolivia’s new president, Jorge Quiroga, announced the implementation of an employment program, mainly in public works, designed to promote an economic reactivation. The program will be financed with soft loans from multilateral agencies.
The Brazilian economy keeps slowing down. Retail sales has been weakening faster than industrial production. Industrial production was growing at 6.2 percent from January to May. From January to June, automobile production was growing at an excellent 21.2 percent. These figures suggest that while the domestic demand sags, external demand keeps the Brazilian industry humming.
Economic activity in Chile, although on a more solid ground than in other Latin American countries, has also been decelerating from last year’s levels. The monthly economic activity index registered about 3.5 percent growth in the first half of this year. Copper prices have edged up in recent months.
Costa Rica’s economic activity index has been falling during the first half of this year. But, excluding high-tech industry, growth approaches 3.0 percent.
Family remittances to Dominican Republic have not been impacted, so far, by the deceleration in the U.S. economy. It has helped soften the effect of weaker U.S. demand for products from the Free Trade Zones, and to a lesser extent on the tourism sector.
The economy has been growing at a healthy pace in Ecuador, spearheaded by construction and commerce, supported by high oil prices. Inflation remains high, 33.2 percent in June.
Family remittances to El Salvador were growing by a strong 11.8 percent between January-July of this year, despite the deceleration of the U.S. economy, where most Salvadorean immigrants live. The trade deficit widened during that period, due to a combination of low coffee prices, high oil prices and imports for reconstruction after this year’s earthquake.
The monthly index of economic activity suggest that Guatemala is headed into a recession. The index has been falling in the first five months of the year, while the government increases taxes.
Honduras and Nicaragua are absorbed by the electoral process. Daniel Ortega maintains a lead in the opinion polls in Nicaragua.
The US slowdown continued to take a toll on Mexico, the economy has dipped to around one percent growth. The Bank of Mexico has responded by increasing liquidity, and thus helping to push down interest rates.
Construction activity is weak in Panama. Private investment in construction projects and public infrastructure investment have plummeted this year. The only dynamism has been observed in low cost housing.
Paraguay and Uruguay are being negatively affected by the economic crisis in Argentina. The situation in Paraguay is further complicated by political instability.
In Peru, president Alejandro Toledo has his economic team already in place and must now deal with the political issues resulting from the Fujimori era and with the reactivation of economic activity.