The Hindu Business Line : US economy: Market too pessimistic?

If the oil cloud lifts — and there is no reason to think the chances are worse than 50-50 — the entire outlook changes. With stable or falling inflation and better growth prospects, rates can stay and the steep yield curve inversion will correct.

It is time for Mr Ben Bernanke and his colleagues on the Federal Open Market Committee (FOMC), the US's interest rate determining body, to uncork the champagne?

Last week's inflation data — the CPI and PPI — both, gross and ex-food and energy were muted enough for them to feel vindicated in their (but for a lone dissenter) pass decision at the last Fed meeting in early August. The benign inflation view, despite rising oil, was the outcome of the meeting consensus that the US economy was slowing as borne out by the Q11 GDP estimate and other weak statistics in recent weeks on housing, jobs, consumer sentiment and leading indicators.

Interest Rates

To an extent, these were offset by better retail sales, manufacturing indices and industrial production. Clearly, however, it is housing and energy that hog the headlines when it comes to talk on the economy.

Mr Bernanke seems to have seen it all coming. In his semi-annual testimony to the US legislatures some weeks back, he thought a pause in raising interest rates was likely necessary and justified, but had to backtrack a couple of days later when forced on the issue.

But, his take on the economy has proved more right than wrong (at least for now), supporting the Fed's move to be on hold. The problem today with being a central banker is that you cannot say you honestly believe interest rates are too high lest the market perceives you are soft on inflation. An asymmetrical bias towards tight monetary policy has become a normal feature of modern central banks the world over.

Recession Risk

The US — nay the global — economy is hostage to oil prices. Expensive energy is bound to take a toll on consumer and business spending and sentiment, especially in America. And, as everyone knows, when America sneezes, the rest of the world catches a cold. An endogenous slowdown might not have been so bad for others like India, who have their own growth engines. But an oil crisis will not spare anybody.

If one were to hazard what is going on in Mr Bernanke's mind, it must be the lurking fear that interest rates have risen too far and too fast. Recession risk is more than inflation risk in a scenario of high oil. Mr Bernanke is right in worrying that growth will slip into negative territory.

Yield Curve

Meanwhile, the market is unambiguous. After the Fed decided to stay put at the last meeting, the yield curve's inversion has only increased.

Thus, 10-year yields are around just 4.8 per cent, while Fed Funds are 5.25 per cent — a clear sign that the market thinks a recession is around the corner.

Is it too pessimistic?

f the oil cloud lifts — and there is no reason to think the chances are worse than 50-50 — the entire outlook changes. With stable or falling inflation and better growth prospects, rates can stay and the steep yield curve inversion will correct. Then will be the time to open the champagne.

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