HB, good summary of events from the Economist.
Straining at the seams
America's inflation is low, but the economy is still dangerously sretched
IF THERE is one person who stands above America's fledgling presidential campaign, it is Alan Greenspan. Most presidential hopefuls heap respectful praise on the head of America's central bank and, from Al Gore to Elizabeth Dole, have recommended that he should be reappointed when his term as Federal Reserve chairman formally ends next May. From Wall Street to Washington, Mr Greenspan is credited with an unsurpassed understanding of America's economy, as he has steered monetary policy to achieve rapid growth, low employment and low inflation. Over the next few months, his acumen will be more necessary than ever.
On one side, there are reasons aplenty to fear inflationary pressure. A batch of recent economic statistics hinted that tight labour markets are at last pushing up wage costs. Financial markets tumbled in early August after the employment cost index, a quarterly measure of overall labour costs, leapt 1.1% between April and June, compared with 0.4% in the first quarter. In the year to July, hourly earnings rose by 3.8%, up from a low of 3.5% in the year to May. Analysts were convinced that these numbers provided enough evidence of an overheating economy to guarantee another quarter-point rise in interest rates, or maybe more, when the Federal Reserve next meets on August 24th.
On the other hand, inflation itself has not yet picked up. Statistics released in the past week show that the major inflation gauges—the producer and consumer price indices—are still extremely well behaved. Producer prices for finished goods rose a mere 0.2% in July (compared with 1.5% a year ago), and consumer prices only 0.3% (2.1% a year ago). This news calmed the financial markets. Although the consensus on Wall Street is still that the Fed is likely to raise rates next week, some economists suggest that this is no longer necessary.
In fact, it is a mistake to take either the labour-market figures or the inflation statistics too literally. Wage pressures are building up slightly, but this is after months of very modest wage gains. At least part of the April-June rise in the employment cost index was a payback for an extraordinarily small rise in the first three months of the year.
Still, it is clear that the labour market is tighter than ever, and on an unsustainable track. More than 300,000 new jobs were created in July, much more than most analysts had expected and three times more than the growth of the labour force could normally sustain. The number of unemployment claims is at its lowest in this economic cycle, and virtually every Federal Reserve district has noted widespread labour shortages.
More important, the benign inflation numbers should not be taken at face value. First, the central bank has to worry about future inflation threats when it decides whether or not to raise interest rates. Since it takes several months for the full effects of changing interest rates to be felt in the economy, it can be dangerous to wait until there is actual evidence of accelerating prices. Moreover, even today's figures show a worrying price pressure behind the benign headlines. Oil prices have risen sharply, and commodity prices in general are firmer. As the economies of Europe and Asia show signs of more vigour, the dollar has been sliding, especially against the yen. On August 18th it passed ¥112, its lowest since January.
Higher commodity prices and a weaker dollar have removed an important source of imported disinflation for America, and firms' input costs are now rising. The producer-price index for core intermediate goods—those goods such as paperboard and plywood that firms use as part of the production process—has risen at a 4% annual rate over the past three months, the biggest rise in four years. Of course, there is no certainty that firms will pass on higher input prices as higher goods prices (if firms raise their productivity they can absorb the extra cost). But, as Bruce Kasman of J.P. Morgan points out, every stage of Federal Reserve tightening over the past two decades has been accompanied by an acceleration of core intermediate producer prices.
How much the Federal Reserve must raise interest rates depends on how far the economy can be trusted to slow by itself. At first sight, it seems to be doing so. Recent retail-sales figures suggest that consumer spending may be slowing. According to economists at Goldman Sachs, consumer spending, after adjusting for inflation, is likely to rise by 3.6% at an annual rate between July and September, certainly much less than the 6.7% real rise in the first three months of the year.
But history suggests caution. America's economy in recent years has continually surprised analysts with its strength. And the next few months could be no exception. Consumer spending is still strong by historical standards. The housing market, an important engine of demand (because people have realised capital gains as they sold their houses, received cash as they refinanced their mortgages and boosted construction demand by building new houses), is still extraordinarily vigorous. Despite sharply higher mortgage rates, housing starts rose by 5.7% in June, though the rate of mortgage refinancing has slowed sharply.
The replenishing of firms' inventories could provide another short-term boost to growth. Currently, inventories are low. Between April and June firms added only $19.4 billion to their inventories compared with $38.7 billion in the first quarter. Most analysts expect a sharp rebound during the next few months, and as companies prepare for the uncertainties of the millennium bug they may well add to their stockpiles. Add to this a strengthened demand for exports as economies in Europe and Asia accelerate, and it is hard to see much chance of the economy slowing down.
Two important—and related—uncertainties could cloud this picture. One is the stockmarket. If Wall Street shrugs off higher interest rates entirely, as it did in June, an orderly slowdown will be harder to achieve. Conversely, a big correction in the stockmarket could precipitate an uncomfortably sharp slowdown. The other unknown is how foreigners will behave. America's trade deficit rose to a record $24.6 billion in June, and the country is heading for a current-account deficit of 4% of GDP this year. As the economies of Europe and Asia perk up, foreign investors who are financing this sizeable deficit may demand substantially higher interest rates to do so.
The recent slide in the dollar and the strengthening in bond yields could be but the beginning. If foreign sentiment turns sharply, America's much-needed economic slowdown could occur more suddenly than anyone expected. And Alan Greenspan would then no longer seem a demi-god. |
