Some have questioned the reliability of healthy January data on sales and production, saying the good news is due to unseasonably warm weather. This group has argued that the data will weaken substantially, beginning with February data, resuming and confirming the “slowdown” in GDP growth rates witnessed during last year’s fourth quarter.
While weather patterns no doubt impacted the data positively, January temperatures certainly don’t explain the acceleration in production, and in business orders and shipments, during the fourth quarter. Moreover, the revised January data on industrial production showed that industrial output expanded at a 5.6 percent annual rate for the fourth quarter while manufacturing advanced at a torrid 9 percent annual pace. Both business equipment and high-tech production expanded faster than previously estimated.
Most important, real-time high-frequency indicators continue to paint a pro-growth picture as well. The Dow Jones Transportation Index rose to an all-time high recently. The AMEX Broker/Dealer Index rose to an all-time high last week, despite fed funds futures pricing-in a 90 percent probability of Fed’s key interest rate rising to 5 percent by mid-year. Junk-bond spreads have dropped more than 110 basis points below their 2005 highs and remain well inside historical norms (near 500 basis points). This would be highly unlikely if a funds rate of 5 percent (or slightly higher) were likely to impose a serious drag on the national economy or materially disrupt global growth.
While I continue to expect additional cooling in the residential real estate market, I believe the linkage between consumer spending and home values has been vastly overstated. Income growth is a much more important determinant of spending trends than home prices, residential real estate market capitalization, or household debt growth. To wit: Changes in income account for 73 percent of the variation in spending over time while changes in median home prices account for only 20 percent of the change in spending. Nominal interest rates actually vary positively with spending.
To be sure, if the residential real estate market goes into a tailspin, households likely would sideline a significant portion of their after-tax income, and spending would decline. However, widespread weakness in residential real estate typically has followed periods of high short- and long-term real interest rates that also weakened employment and output. Today, real short rates have normalized while long rates remain well below historical norms.
This is not to say there are no significant risks to the outlook. If Congress doesn’t act to extend the 2003 tax cuts, tax rates on capital will rise, which would depress after-tax rates of return to capital and stunt growth. Even worse, there are rumors circulating that China could be tagged a “currency manipulator” by the U.S. Treasury, which would only invite a potentially disastrous protectionist legislative response from Congress (i.e., a 27.5 percent tariff on Chinese goods).
The neo-mercantilist flat-earth society, which includes members of both parties, doesn’t seem to understand that a fixed (and now sliding) peg for the Chinese yuan simply means that China outsources its monetary policy to the Fed. This is no different from the benefits many countries have achieved by scrapping their own currencies in favor of the dollar. It is telling that the anti-China crowd in Congress has not taken aim at other dollar-linked or dollarized countries with destructive tariff proposals or charges of currency manipulation. Where are the tariff threats or cries of currency manipulation against Ecuador, El Salvador, East Timor, Panama, Lebanon, Hong Kong, Saudi Arabia, Kuwait, or Malaysia, all of which either use the dollar as legal tender, fix their currencies to it, or manage them in a tight band against it? Fixity is the antithesis of manipulation, not the cause of it. Apparently a passing grade in Economics 101 isn’t a prerequisite for ascending to the U.S. Senate.
As Nobel Laureate Robert Mundell recently argued, an appreciation of the yuan could impose deflationary pressures on the Chinese economy, fan tensions in rural areas, and cut China’s growth rate. The result likely would be slower Chinese growth and lower incomes, which would cut the demand for U.S. exports — precisely the opposite of the intended effect. While a modest appreciation of the yuan probably would carry few risks given the dive in the dollar’s value during the last few years, a significant appreciation would surely be deflationary.
It is also quite telling that the strongest advocates of yuan appreciation (or tariffs on Chinese goods) never advocated a devaluation of the currency when China was dragged into deflation by the steady appreciation of the greenback. In other words, the protectionists in Congress want it both ways, which means they are both inconsistent and wrong.
Currency risks don’t stop with China either. The halving of the dollar’s value against sensitive price-level indicators during the last several years also creates risks for the expansion here. If core inflation moves above the 3 percent threshold, a higher probability than most believe, the funds rate eventually could be headed to 6 percent. This is why it will be increasingly important for the Federal Reserve to heed sensitive market prices as short rates move into the 5 percent zone by mid-year.
A sensitive-indicators approach at the Fed and lower tax rates on the factors of production would sustain and deepen the expansion. However, higher tariffs, a trade war, and a tax hike on capital could end it. In this vein, the Bush administration should take a stiff stand against protectionism in all its forms and lobby relentlessly for the extension of the 2003 tax cuts.
Anything less wouldn’t be prudent — or pro-growth.
— Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.