The Hindu Business Line : Data belie Greenspan's optimism

Data released in the US reinforce the scepticism that the Federal Reserve Chairman, Mr Alan Greenspan's cheer is not well founded and that the American economy has to grow furiously in 2004 second half to justify the optimism of the Fed's growth forecasts. Disappointed by durable goods orders and second quarter GDP data, economists are betting on non-farm employment figures. And indeed even if a significant number of jobs were created, it may not materially alter the premise that the economy has lost momentum as it enters the second half, says V. Anantha Nageswaran.

IN A column titled, `Testimony or Convention Speech' (Business Line, July 22), yours truly had argued that the Federal Reserve Chairman, Mr Alan Greenspan's optimism was not well founded and that the American economy had to grow at a furious pace in the second half of the year to justify the optimism implied in the Federal Reserve forecasts for economic growth. Since then, data released in the US have reinforced our scepticism.

String of weak economic data

A crucial piece of data was the orders for durable goods for June. Despite a revised lower drop in May, the data for June showed that there is no momentum in capital spending. Bulk of the growth came from Defence aircraft orders. The story in the technology land is one of continued inventory build-up.

The Beige Book — an anecdotal survey of economic conditions — complied, in turn, by various Federal Reserve banks, revealed that economic activity in the US moderated both in June and in July. Goldman Sachs' activity index showed a noticeable drop in July. Their economists interpret the components of the index as suggesting weaker output and higher inflation since both input and output prices components surged. However, in real economic data, there is no smoking gun. Inflation remains quiescent. The annual change in the price index for core personal consumption expenditure in the second quarter was 1.55 per cent — well above the low of 1.1 per cent reached in the third quarter of 2003 but equally, well below the high of 2.2 per cent reached in the last quarter of 2001.

Wages and salaries (this does not include benefits such as pensions and health insurance payments that companies make) of private workers are rising at an annual rate of 2.6 per cent and hence, as such, are not inflationary.

Weak momentum going into the second half

To cap it all, the second quarter GDP growth came in at 3.0 per cent (annualised rate), whereas economists, on average, expected 3.7 per cent.

Although the growth rate for the first quarter was revised higher from 3.9 per cent to 4.5 per cent, revisions to data for 2001-2003 show that the economy has recovered somewhat meekly from a shallow recession in 2001.

Growth was driven largely by investment spending and less by private consumption spending. Within investment spending, housing contributed significantly. However, it is unlikely to continue.

The Housing Affordability index constructed by the National Association of Realtors dropped to 124 in June (provisional). It has dropped for the last two months form the average reading of above 140 in the first four months of the year.

With a rise in the mortgage rate to over 6 per cent in June from 5.77 per cent in May, monthly payments as a percentage of medium income has crossed 20 per cent whereas the average in the last three years never exceeded 18.5 per cent.

Having been disappointed by both durable goods orders and second quarter GDP data, economists are now betting on the non-farm employment figures for July due for release on August 6.

It is expected to compensate for the tepid jobs growth in June. We do not know and even if the data reveal that the economy generated jobs in significant numbers in July, it would not materially alter the premise that the economy had lost considerable momentum entering into the second half of 2004.

While a correction in the overvalued housing market (see chart) would make the affordability index improve, it would reduce the net worth of existing households, further crimping their purchasing power, when monthly incomes are rising far too slowly than they should be, at this stage of the economic cycle.

Higher crude oil price to produce stagnation

Further, the price of West Texas Crude Oil scaled nearly $44 per barrel on Friday, amidst escalating violence and instability in Iraq.

The rising crude oil price has defied OPEC pledge to increase production. Demand is clearly too strong as energy inefficient consumers like India and China enjoy high economic growth. Debt-heavy American households would choke on high oil prices and producers' margins would come under pressure.

Yet, inflation is appearing everywhere except in American economic data, withholding the smoking gun that the Federal Reserve needs to lift the Federal funds rate off the floor.

Rates to rise so they can be lowered in 2005

Amidst all this, one could sense, in the Chairman's testimony to the US Congress last week, some anxiety on his part to do so, if only for him to have a higher base from which to lower them next year.

That is the only justification for him now to raise rates. So, it appears that the Federal funds rate could rise to 1.75 per cent before the year ends. Anything more would leave the chairman with a lot of explaining to do, in an election year, to the Republican Party whose ideology he identifies himself with.

Perverse US dollar firmness unlikely to last

Given this backdrop, it is a surprise that the US dollar has gained slightly against global currencies in recent weeks. It must be only because Asian governments continue to intervene in currency markets to keep their exchange rates competitive.

Data on foreign purchase of US long-term securities suggests that Japan has increased its holding of US Treasury securities by more than 20 per cent this year, until May. In comparison, China has been far more tepid.

Interest rate speculation and possibly strong employment data for July would keep the US dollar well bid in the short-run. It could even make further gains as rising oil prices undermine the Asian growth story and raises risk premium, in general, on Emerging market assets. However, the structural problems of the American economy entail a much weaker dollar.

In the words of Prof Wynne Godley, "... what is not in question is that imbalances of many different kinds have already been allowed to build up on an unprecedented scale. Trends and processes have developed which cannot continue for much longer and which may not correct themselves spontaneously in an orderly way. The authorities in the US and in the rest of the world should be therefore be giving active consideration to pre-emptive action, preferably in collaboration with one another." In other words, he is calling for a substantial depreciation of the US dollar in which East Asian countries would acquiesce. If they do, it would reveal that the recent East Asian cyclical recovery was built once again on superficial foundations just as Prof Paul Krugman once claimed that the entire East Asian miracle was excess investment and not much else. That is a story for a different occasion.

For now, investors should stay the course on avoiding the US dollar and steadily accumulate the euro and gold on any (irrational) short-term weakness that they are experiencing, as now.

(The author is an economist based in Singapore. These are his personal views. Address feedback to nageswar@singnet.com.sg)

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