Canadian Financial Post
Saturday, January 10, 1998
U.S. economy starts losing lustre
By PETER MORTON
Washington Bureau Chief The Financial Post
With more leading indicators pointing south, even President Bill Clinton is getting worried the
U.S. economy will be sideswiped by the deepening Asian crisis.
The White House took the unusual step Friday of saying it believes fallout from Southeast Asia
will cost the U.S. economy between 0.5% and 1% in growth this year.
"The fundamentals in our economy driving growth and job creation are so strong that I believe
we are in an excellent position to weather the impact," said White House economic adviser Jane
Yellen.
But the U.S. administration is so concerned that Clinton telephoned Indonesian President
Suharto to urge him to implement economic reforms tied to a US$43-billion International
Monetary Fund rescue package. U.S. officials and IMF managing director Michel Camdessus
were heading to Jakarta this weekend to press the Suharto government.
"Asia appears to be heading for a debt crisis," said Morgan Stanley Dean Whitter's
London-based economist Tim Condon. "It is unlikely that borrowers in Thailand, Indonesia and
Korea will be able to repay their external debts, conservatively estimated at US$300 billion."
Meantime, recent economic indicators -- ranging from the purchasing management index to
wholesale prices -- profile a U.S. economy heading for a major slowdown on its own, without
help from Asia.
"These indicators are all flashing a distinct slowdown," said senior economist David Rosenberg
of
Nesbitt Burns Securities Inc. in Toronto.
U.S. growth is expected to hover around 2.5% this year, down from the 3.5% expected for
1997.
Rosenberg said the stock markets ignored especially strong job figures in the U.S. on Friday
because of distractions from Asia.
The U.S. unemployment rate in December was 4.7%, after beginning 1997 at 5.3%. Last year's
average unemployment rate of 4.9% is the lowest since 1973. And December payrolls in the
U.S. also jumped by 370,000, much higher than expected.
"This is most likely the strongest job data we are going to see for quite a well," Rosenberg said.
But mounting layoff notices, coupled with lower earnings among key U.S. companies such as
Nike Inc., Netscape Communications Corp. and Adaptec Inc., point to a slowing economy.
Employment forecaster Challenger Gray & Christmas said there were 58,293 layoff notices in
December, up 56% from December 1996. The trend could strengthen as Asian shockwaves hit
the U.S.
About 30% of U.S. exports and 40% of its imports come from the region, Rosenberg said.
The good news is most economists expect U.S. interest rates to head down, not up, as Federal
Reserve chairman Alan Greenspan had been hinting just weeks earlier.
"Deflation, not inflation, will come to dominate the Fed's debates and, we believe, the Fed will
ultimately ease monetary policy," said Bruce Steinberg, chief economist at Merrill Lynch & Co. in
New York.
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Saturday, January 10, 1998
Using the 'd' word
Economists are watching closely as deflation becomes the latest threat
to global markets
By DAVID THOMAS
Economics Reporter The Financial Post
When Asian markets stumbled into a deepening crisis last fall, a dusty old term began to creep
out of the textbooks and back into common parlance in economic circles.
That term is "deflation," and after U.S. Federal Reserve chairman Alan Greenspan mentioned it
16 times in a speech last weekend, it's now on the lips of market watchers and policy makers
worldwide.
Deflation refers to a sustained period of declining prices that can have a devastating effect on
the
economy.
It hasn't been experienced in North America since the Great Depression of the 1930s, but the
question now making the rounds is whether deflation could make a comeback.
Economists lifted a corner of the lid on this ugly can of worms last year, but Greenspan has now
ripped the lid right off.
"When I read what he said, I said to myself: 'This is a big deal,' " says Nesbitt Burns Inc. chief
economist Sherry Cooper.
"Greenspan doesn't conjecture idly about anything. The debate has been opened."
That debate is centred in the U.S., but is being closely monitored by economists in Canada and
elsewhere because the effects would be global.
Greenspan stressed there was no risk of deflation in the U.S. soon. But as always, analysts
were
more interested in what he meant, rather than what he said.
Like those of many central bankers, his comments are thoroughly dissected to read between the
lines for hidden meanings. And not surprisingly, different observers came to different
conclusions.
Bond traders quickly surmised Greenspan was telegraphing that the Fed's next move would be
to lower interest rates. Until that point, the consensus opinion was to expect higher rates.
On the other side of the fence, Federal Reserve governor Edward Gramlich expressed surprise
at the bond market's reaction and downplayed the possibility of deflation in the U.S.
Greenspan's speech focused on the perils of accurate price measurement and his comments on
deflation were "mainly a digression," Gramlich told Reuters.
Cooper disagrees, arguing that Greenspan was signalling that deflation has become a plausible
threat, though not yet a real one.
As such, central bankers are going to have to watch out that their monetary policy doesn't kill
inflation entirely. The result could be to conjure up an even more frightening monster, she says.
"I
think inflation is yesterday's bogeyman. I don't think we could see deflation in 1998, but I
wouldn't dismiss it for the future."
She agrees with the bond market's reading of Greenspan's speech and says the tea leaves may
spell more trouble for the Bank of Canada.
"I'll bet you Greenspan's next move is to [reduce interest rates] and I think it'll be in the next few
months."
That could complicate the next move for Bank of Canada governor Gordon Thiessen, who has
indicated the bank is still on a course of raising rates to keep the economy from overheating.
The currency market is also expecting higher rates in the near future. A shift to lower rates could
provoke a serious run on the already beleaguered C$.
"Thiessen has a serious problem and he knows it," she says.
Deflation has been gone so long, it sometimes sounds as if economists aren't sure what it looks
like anymore.
"The definitions are definitely muddy," offers Cooper.
Disinflation, which refers to a decline in price advances, is much more common. Periodic
declines in actual prices are especially common for commodities and other cyclical sectors.
But a real deflation would suggest a widespread decline in the general price level of goods and
services.
"What deflation is, actually, is a period of persistently falling prices - not a one-shot reduction,"
explains Gramlich.
With the expectation that prices will come down in the future, investment decisions tend to be
delayed in a deflationary environment and economic activity grinds lower.
Deflation's effect on the stock market, where values are based on future streams of earnings,
can
be devastating.
The forces economists feel could trigger a shift from inflation to deflation are a global glut of
capacity and competitive devaluation of currencies. These are seen as the cause of Asia's woes
and this Asian flu is only beginning to take its toll on the rest of the world, they warn.
Price declines have emerged most markedly in commodity prices generally in base metals in
particular.
Reduced Asian demand has put downward pressure on copper, nickel and aluminum. Copper is
trading at a four-year low, while nickel and aluminum prices haven't been this weak for 42
months
and 15 months, respectively.
Many analysts suspect commodity prices are headed still lower.
Ed Yardeni, chief economist at Deutsche Morgan Grenfell Inc. in New York, says the price of
gold acts as a good leading indicator of price direction for commodities in general.
He says gold's steeper decline likely points to a coming collapse in commodity prices (see
chart).
Gold is taking a beating on several fronts. Its previous allure as an anti-inflation hedge has all
but
disappeared with the erosion of inflation. The price has also taken a huge hit because of high
levels of central bank selling last year and expectations of more in 1998.
Just to make a dismal picture bleaker, warmer weather and increased supply have conspired to
send oil prices tumbling as well in recent weeks.
Deflationary pressures on the commodity front are due to be compounded by weaker prices in
manufactured goods and other exports from Asia. Many Asian currencies declined more than
50% in 1997, giving their products a price advantage over non-Asian competitors.
Says Cooper: "We're importing price deflation."
Chrysler Corp. chairman Robert Eaton said this week the U.S. auto manufacturer doesn't expect
to raise the prices of its cars and trucks in 1998 or 1999. "There's no opportunity for pricing in
this market," he said.
On the car lot that means prices are actually being slashed in many cases. Consumers are able
to
pick up a new car for as much as $3,000 less than last year's cost, Cooper points out.
In the high-tech sector, the price of some computer chips tumbled more than 60% last year. The
saving grace for that sector has been massive increases in productivity that have helped firms
stay
profitable.
In his speech last week, Greenspan said deflation has the potential to be at least as
economically
damaging as inflation.
"A drop in the prices of existing assets can feed back onto real economic activity, not only by
changing incentives to consume and invest but also by impairing the health of financial
intermediaries."
So, are there already signs of deflation?
Some economists say yes, pointing in particular to commodity prices. Others say no, arguing
that
the spectre of deflation is overplayed and that disinflation is the prevailing force.
Yardeni says there are definite deflationary clouds on the horizon.
He looks at various measures, including import prices and a monthly indicator called the
producer price index.
The PPI declined 1.2% in 1997, the biggest drop since a 2.3% decline in 1986. Yardeni expects
to see another full year of declining prices in 1998.
But that doesn't necessarily point to deflation, counters Jeff Rubin, chief economist at CIBC
Wood Gundy Securities Inc.
He figures inflation on the service side of the economy will be enough to keep deflation at bay.
Services account for about two-thirds of total economic output in the U.S., he estimates.
According to Yardeni, product prices are already showing signs of deflation and service prices
could follow next.
The consumer prices index - the main measure of inflation - should average 1.5% this year in
the
U.S. but could begin deflating in 1999 or 2000, he forecasts.
His anti-deflation prescription is to have the Fed begin lowering interest rates soon or deflation
will become a reality.
He is joined in his assessment by other leading Wall Street economists, including Bruce
Steinberg
of Merrill Lynch & Co.
"Global deflation pressures are intensifying," he observed in a recent report.
Steinberg predicts the Fed's next move will be to lower interest rates, saying: "Those worried
about inflation are fighting the last war."
On the subject of war, it is Yardeni's contention that the end of the Cold War in the late 1980s
helped to set the stage for the current deflation-friendly environment.
"History shows that inflation occurs during war times and that deflation is the norm during
periods
of peace," he says.
"Central bankers have kept the forces of deflation at bay, but they have not defeated them."
Yardeni says there is a real risk that the death of inflation means global economies may be
headed for a climate of deflation that could endure for decades.
But while deflation's believers are growing in number, their fear is misplaced, say others.
One skeptical voice is the London-based Economist, which dismissed deflation as "an
increasingly fashionable theory" in a November issue.
While it documented the global glut in industrial capacity and supply in some sectors such as
cars
and computers, the article listed many sectors whose prices continue to climb.
Airline tickets, aerospace parts and hotel rooms were all cited as heading higher in price.
"Inflation, not deflation, remains the bigger risk," it concluded.
Charles Plosser, an economics professor at the University of Rochester, went even further in his
dismissal with a December academic paper entitled Global Glut, Deflation and Other Nonsense.
"It's gibberish," he concludes of the current round of deflation theories. "Monetary policy will
determine whether or not there is a deflationary trend in the U.S."
That means Greenspan has the anti-deflationary tools at hand in the form or lower interest rates
and/or an increase in money supply.
Although the diagnosis may differ, that prescription is exactly the same one advocated by
Cooper, Yardeni, Steinberg et al.
Depending on what Greenspan really meant last week, that may be where the Fed is already
headed.
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