The recent financial-market weakness is solely attributable to near-term uncertainty, not a new downturn in the economy. Iraq’s disarmament, the fate of the president’s tax bill, expensive oil, and dollar weakness are all presenting major near-term problems. But these issues will work out favorably. Long-term optimism is justified.
The fundamental engines for a continued U.S. economic expansion — 131 million employed workers, record-low interest rates and inventory levels, record-high institutional money fund balances, and rising commodity prices — indicate a reflation rather than a deflation.
In the event of an Iraq solution, business confidence will turn up, the likelihood of a major, growth-oriented tax cut will rise (along with Bush’s popularity), share prices and the dollar will strengthen, and oil and bond prices will fall.
For each near-term concern, there is a bright outlook for the longer-term.
Wall Street bears are worried about deflation and inflation (they’re equally divided between these two camps). But we can’t have both. Over time, the piece-by-piece reflation now showing up in commodity prices will spread rapidly to other parts of the economy, and the late-stage deflation worriers will have to throw in the towel.
The market is also split on Iraq. One half worries about dragged-out inspections in Iraq, and the other half worries about the uncertainties of war and terrorism. But President Bush has made it clear that Iraq’s disarmament is not a polling issue and can’t be allowed to drag on. There will be progress on Iraq in the first quarter.
As for the dollar, the key issue is whether a weak dollar trend is under way, creating the risk of inflation and forcing the Federal Reserve to hit the brakes. This doesn’t seem likely.
Short-term currency movements are like a popularity contest. For now, the U.S. is out of favor, in large part due to Iraq and the heat of the global debate over U.S.-Iraq policy (joined by former President Clinton last week). President Bush recognizes the danger of a weak dollar trend. He and the Treasury will make that clear in due time, and the dollar will strengthen against the euro, yen, and gold when an Iraq solution is reached.
Right now, the Treasury is in a quiet period as secretary nominee John Snow heads to confirmation hearings. This gives the impression of dollar neglect. (The dollar weakened even more prior to Paul O’Neill’s confirmation hearings in early 2001.) But Secretary Snow’s first dollar comments should give an indication of how the administration will respond to dollar weakness.
Wall Streeters are also worrying about oil prices. Distant oil futures contracts spurted higher last week, indicating a market perception that OPEC and Venezuela production issues will drag on. December 2003 oil rose to $26.61 — and artificially expensive oil (sustained anywhere near current levels) spells a global recession. But oil prices will fall sharply once uncertainty on Iraq abates. Again, the key is that Iraq is dealt with soon. There’s little reason to think this won’t be the case.
Finally, a major, pro-growth tax cut is likely in 2003, especially if an Iraq solution occurs. The legislative progress of the Bush tax proposal will dominate financial markets for months once Iraq disarmament takes place. The proposal is valuable for its near- and medium-term growth effects — both of which are substantial. Equally important, this tax reform, if it succeeds, would open the door for other major Washington reforms, and would force better tax policies abroad.
Yes, the near-term concerns of the market are substantial, but the mid-winter gloom on Wall Street won’t extend into spring.
— Mr. Malpass is the Chief Global Economist for Bear Stearns.