There is considerable disagreement regarding the future path of the U.S. economy. Manufacturing data continues to trend lower, but job growth and retail sales have surprised on the upside. In this environment, some financial analysts argue that further increases in the inflation rate are around the corner, while others quarrel that an economic slowdown is imminent. I disagree with both points of view, yet this is not to say there are no potential downsides for the U.S. and world economies.
The futures market is instructive here. A close examination of euro-dollar futures suggests that the markets do not expect any significant rise in short-term interest rates past the end of the year. The markets are expecting a flatter yield curve (the difference between long- and short-term bond yields), which indicates that there is no recession on the horizon. More, the decline in long-term yields and the expected flatter yield curve point to a decline in the inflation rate. A higher stock market can be expected in this environment.
Increases in the fed funds rate have slowed down money growth, as the Federal Reserve intended. The Fed also has made pronouncements signaling that the time has come to tighten lending standards. I believe the Fed is sending a clear message to banks and financial institutions: Maestro Alan Greenspan wants to de-lever the economy and reduce overall credit creation. This is best accomplished by an increase in the effective reserves held by the banking system. Moral suasion is a simple way to get us there as well. Last year, when Chinese banking authorities effectively raised some reserve requirements to 100 percent, banks effectively stopped lending.
Why is the Fed doing this? It simply wants to reverse the situation it created in the aftermath of the recession and 9/11. Sir Alan has developed a reputation as a crisis fighter and has never hesitated to provide the liquidity and/or credit needed by the economy during periods of emergency. The last recession was no exception. In fact, looking back at the aftermath of the 2000-01 recession, it is easy to see why the price of credit declined so fast and various spreads (such as bond yields) remained so narrow. When there is an abundance of credit, it can safely be argued that risk will not be able to command a premium, hence the narrowing of spreads. However, as credit is restrained and market conditions return to historical standards, the spreads among assets of varying risks will also return to historical levels.
The question is now, How will this “spread widening” be accomplished? If, as I believe, inflation is under control, spread widening will come by way of an increase in the yields of riskier assets. Therefore, high-yield instruments, such as emerging-market bonds, will not sail with the wind at their backs this time around.
My outlook is bullish, but not everything is as rosy as I had hoped. Last quarter I was quite optimistic about President Bush’s “opportunity society” programs. Although he is back on the stump pushing his agenda, the consensus seems to be that there is little chance his Social Security reforms will get through Congress. Another disappointment is a delay in the release of the president’s tax-commission report. The holdup (to late August or early September) could create some market uncertainty during the dog days of summer.
It also is somewhat disappointing that the administration is not touting all of today’s good economic news. For instance, tax-revenue collections are coming in at much-higher-than-forecast levels, meaning lower tax rates have sparked people to work harder and have encouraged corporations to unlock capital. All this is making the U.S. economy more efficient. The Bush tax cuts have had a lot to do with this, and yet the administration is quiet on the subject. The White House is also failing to make the point that any potential deficit or budget problem stems from overspending, and not a lack of revenue.
It also is disappointing that so many economists and news outlets are framing today’s high oil and gas prices in an incorrect manner. At issue is what determines the high price of oil. During the 1970s — at the height of OPEC’s monopoly power — we experienced a supply shock and the resulting higher oil prices were a major source of worldwide recession. But today, the rise in oil prices (as well as the prices of basic commodities) is demand driven, which is bullish for the world economy. Simply, demand shocks caused by economic growth are bullish.
Ask yourself the following question: What would happen to the current price of gasoline if OPEC announced it was increasing production by 20 percent? Your first impulse might be to say that the gas price would plummet. But ask yourself this follow-up question: Who will refine this oil and where will they refine it? If, as the press reports, refineries at home and abroad are running at near full capacity, it would be almost impossible for oil companies to increase the amount of their refined product. Hence, the short-run impact of higher oil production on the price of gasoline would be nil. The gas price would remain high as long as the world economy continued to grow and refining capacity was not expanded.
The short-term effects of increases in all commodity prices easily can be established. The expansion of the world economy and the lagging increase in the production capacity of commodities will lead to higher commodity prices. These higher prices will benefit the commodity-producing countries. Also, in order to satisfy higher world demand and limited supplies, higher prices will “crowd-out” or squeeze the slower-growing economies of the world.
Low inflation and low interest rates will allow the world economy to continue to expand at a healthy pace during the second half of the year. However, the rate of expansion will not be uniform across countries. Resource-based economies will continue to do well. But economies that look to compete head-to-head with Chinese exports will underperform. It is in these countries where we are likely to see an increase in protectionist pressures — such as those bubbling out of Washington today. Hopefully our legislators will choose free trade. We already have steady growth and low inflation on our side. Why jeopardize these now?
– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.