The Hindu Business Line : US Fed: Between Scylla and Charybdis

The US economy has come this far unscathed simply because the dollar is the world's reserve currency and Asian central bankers allowed this situation to continue despite deteriorating fundamentals. Sooner than later, however, they will demand higher interest rates on dollar holdings to compensate for the diminishing purchasing power. That would be the final blow that ends an era of low interest rates, deficit spending and, indeed, US consumption-led growth, says SHANMUGANATHAN N.

Opinion varies among the financial community on the next move of the US Fed chief, Prof Ben Bernanke. Will he raise or lower interest rates? The optimist camp about US growth believes that after very subdued growth in Q1, the country will witness higher growth in the latter half of the year, leading to inflationary concerns which would cause the US Fed to increase rates. The not-too-optimistic camp believes that growth will falter in the quarters ahead as a collapsing housing market prompts the Fed to decrease rates.

And what do this writer and his analyst colleagues believe the outcomes will be? Neither. The US will indeed go into a recession (and a severe one at that) and instead of decreasing rates, the Fed would be forced to raise rates.

This article explains why the "eventual" outcome in the years ahead would be stagflation — that is, extended recessions combined with high inflation and the consequent increased interest rates.

Before explaining why long-term interest rates are headed higher, it would probably be worthwhile to see why the immediate outcomes for the US economy would be unpleasant under any monetary policy combination that Bernanke could attempt.

Cutting Rates, Leading to Collapsing Dollar

If the US does enter a recession under the weight of a collapsing housing market (a very probable outcome), then in an ideal situation the US Fed would want to cut rates to prop up the housing market and, therefore, the consumer-spending-dependent US economy. But what a cut in interest rates at this stage would cause is a further depreciation of the dollar against other currencies, as all other countries have been increasing interest rates to ward off inflationary concerns in their economies.

An earlier article explained why the US dollar ("The Dollar Bubble of USA.com," Business Line, May 11, 2007) is on the verge of a massive depreciation against other major currencies. This situation of a weaker dollar would lead to increasing consumer prices for imported goods and thereby higher inflation. So the Fed's ability to maintain a negative real interest rate under such a scenario would be pretty much impossible.

Raising Rates, Leading to a Recession

The US economy is already teetering on the verge of a recession, with less than 1 per cent growth for the last two quarters.

In fact, had the US been measuring inflation correctly, it would already be in a recession.

The decline of housing prices has already started to decrease the consumption numbers, affecting GDP growth rates that grew at an anaemic 0.6 per cent for Q1.

So, under the circumstances, if the US Fed raises interest rates, it would hasten the collapse of the housing bubble, plunging the economy into a recession.

So the options before Prof Bernanke are not entirely pleasant. The outcomes in either scenario, of cutting or raising rates, would eventually lead to a recession combined with higher inflation.

What will Ben do?

As he has been doing for the last several months, perhaps nothing. The US Fed really has no choice other than to make some noises as to how it will raise rates to ward off inflation or cut rates to maintain growth, while really not doing anything that would lead to either of the two scenarios.

This situation, however, cannot continue indefinitely and ultimately it will be forced to choose between propping up a faltering economy and protecting the integrity of the dollar. Given the structural imbalances in the US economy, a recession would be a necessity to correct the excesses created by a near two-decade-long loose monetary policy.

So, the only legitimate action that could be undertaken by the Fed is to raise rates to protect the dollar depreciation against other currencies and also to attract the necessary capital investments required for the rebuilding activity.

These rates have to be substantially higher than the current 5.25 per cent and these higher rates are going to send a lot of dollar-denominated assets (US real estate, stocks, bonds) into a tailspin.

Banking on status quo

Most analysts assume that the US Fed will be able to drop interest rate at will and that, as and when there are symptoms of weak economic growth, all it has to do is to lower the rates, stimulating growth. While this certainly seemed true under the former Fed chief, Mr Greenspan, we should also remember that he benefited from a largely benign commodity cycle that prevented the effects of a loose monetary policy from showing up in the inflation numbers.

In general, no central bank can "officially" afford to maintain a negative real interest, even for short periods. Even when they resort to distorting inflation numbers to portray an image of positive real interest rates, the game can go on only for a certain period before market realises the truth. When that recognition happens in the market-place, the savings habit of a society gets altered on a more-than-temporary basis, which could be disastrous for an economy in the long run.

In fact, even the current US negative savings rate could be an outcome of holding interest rates too low for too long. Therefore, to assume that Mr Bernanke will cut interest rates in the face of rampant inflation is plainly wrong. The US dilemma also shows the severe limitations of using monetary policy instruments to stimulate growth. While many would point to the long period of growth that the US economy has enjoyed over the last two decades, this is indeed a chimera. The growth of the US economy has not been built on the edifice of just debt and consumption.

Over the last two decades the US has transformed itself from the world's largest saving nation to the largest debtor nation; from a first-rate exporter of manufacturing products to an importer of everything — from manufactured goods, farm products and services — while the only growing exports has been that of the dollar.

They have gotten this far unscathed simply because the dollar enjoyed the status of the world's reserve currency and the existing bureaucratic status quo thinking of Asian central bankers that allowed this situation to continue despite falling fundamentals. While there is no real insight into when such thinking by the Asian central banks will change, sooner than later, they will start demanding higher rates on the dollar holdings to compensate for the diminishing purchasing power. That would be the final signal that ends an era of low interest rates, deficit spending and US consumption-led growth.

(The author is a Director at Benchmark Advisory Services and can be contacted at shan.sundaram@benchmarkconsulting.in . His previous articles can be accessed at http://financial-musings.blogpsot.com)

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