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Ajay Jaiswal

THE latest Congressional testimony by the Federal Reserve Chairman, Mr Alan Greenspan, to the Banking Committee of the US Senate stands out in more than one ways.

One, it admits that the US economy is now in a phase of expansion that is self-sustaining. Second, it goes into detail of reasons for the strength of growth, chances of upward surprises and evaluates how the various sections of the economy would cope with such a transition.

The US economy is growing at a healthy pace even though there has been a patch of soft data releases in June. One must keep in mind that the leading indicators and the manufacturing sector surveys do point to robustness in the second half.

There is a significant increase in capital spending over the last one year. The primary reason for this is low cost of the capital and the investment tax incentives.

The US administration had given tax incentives on capital expenses in 2002, which have been enhanced and carried over in to this year. The order book of non-defence capital goods looks healthy.

Most of the economic pundits have been citing the weak job growth as one of the reasons for the weakness in the recovery. Some try to look at the minimum number of job additions from the trough to be able to call the recovery healthy. Nevertheless, the non-farm payroll employment, which was growing at about an average of 60,000 per month in 2003 is growing at average of two-lakh per month this year.

This improvement in the labour market is also having a positive impact on the household spending. Low interest rates over the last few years had given the household the opportunity to lower their financial obligations.

One would remember that the indebtedness of the household sector had been one of the major worries for the Federal Reserve and had even forced it to prepare for deflation last year. The sector has had good time to restructure and dilute its susceptibility to the increase in interest rates.

The Federal Reserve believes that the inflation has moved up largely due to factors that could be transitory in nature. The fuel and energy prices have shot up with the crude prices moving above $40 a barrel and staying high. The Core Consumer Price Index is the measure of the inflation after taking away the impact of the volatile fuel and energy component. Core CPI, which was at 0.8 per cent at the end of last year, is now close to 1.8 per cent. This price rise is not entirely due to cost pressures. There has been a surge in profit margins.

The non-financial corporation profits as a share of their output has moved up from a low of 7 per cent in the third quarter of 2001 to 12 per cent in the first quarter of 2004.

The share of profits as a ratio of their nominal income is now 12 per cent, which is well above the long run average over the last three decades of 10.5 per cent.

There is also an increase in hourly wages of around 4.5 per cent in the first half of this year. Such pressures would rein in the growth in profit margins.

The Federal Reserve seems to now believe that there could be a possibility of surprise on the upside over the rate of growth of the economy or the surge in inflation.

The surge in inflation could also be due to energy prices moving further up due to supply disruptions from unforeseen attacks. In this testimony, the Chairman spent a good deal of time to relay his comfort of the ability of the various sections of the economy to withstand any change in pace of return to neutral rate. Though there are no clear indications over what the Federal Reserve believes to the neutral rate, it could be some where between 2.5-3.5 per cent.

The rate at which the Federal Reserve would have to return to this rate could vary and may not remain `measured'. Household have already made adjustments as discussed above and may not be exposed to the extent earlier.

The carry trades that had been put in to take advantage of the low short-term interest rates may also be on the decline. There has also been a large increase in the net short positions in the 10-year Treasury note futures.

These contracts are now at an all-time high since the 10-year Treasury note futures started trading in 1980s. This offsets large part of the interest rate exposures of the carry-trade positions.

Mortgage market has also adjusted itself. The increase in interest rate outlook has significantly reduced the amount of refinancing this year.

The mortgage backed security portfolio has negative convexity and they need to sell Treasuries or pay fixed on the interest rate swaps when the interest rates move up to adjust their durations.

As the refinancing has reduced and the portfolios have made some adjustments, any significant pressure from this side on the long-term interest rates is less likely.

All-in-all household and business are now reasonably well prepared to cope with a transition to a more neutral stance of monetary policy. The Federal Reserve is guarding against the surprise and making sure that none of the sections of the economy is caught off-guard to their peril.

This would also be a message to all the other central banks to look at their respective economies and chalk out road map in case a stronger action of interest rates may be warranted.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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