It's Still The Economy, Stupid


Monday, June 14, 2004  

The imminent return of global uncertainty

Retail Sales were up 1.2% in May. The year-over-year increase in retail sales is 8.9%. Mind you these numbers are not inflation adjusted. Gasoline sales were up 4% for the month and 22.5% for the year and building materials store sales were up 16.6% over the year - if that helps put this in perspective at all.

Because the U.S. doesn't save and stimulates the economy through borrowing, it's not surprising that the April trade deficit surged to a record $48.3 billion.

Your daily history lesson. The last Fed tightening cycle occurred from August 24, 1999 to May 19, 2000. The target Fed Funds rate went from 4.5% to 6% with four increases of 1/4 point and a final increase of 1/2 point. The stock market peaked in March 2000 before the tightening cycle was completed. Employment growth also peaked in March 2000 at an annual rate of 2.6%. The 1980s tightening cycle began in September 1987 with the discount rate (the Fed's benchmark at the time) at 5.5% and ended February 24, 1989 with a 1/2 point increase to 7%. Employment growth peaked around January 1989 at a 3.3% annual rate. As the economy has become more sensitive to interest rates, it appears the lag between higher interest rates and slower growth has shortened significantly.

The Fed is widely believed to once again begin tightening monetary policy with their next press release on June 30th. The futures market indicates the odds of a 1/4 point increase after the meeting is 100% and the odds of another 1/4 point increase after the August 10th FOMC meeting is 100%.

Doug Noland relates a couple of interesting factoids from the latest Flow of Funds report. First, annualized Foreign Direct Investment in the U.S. the past quarter was $2.1 billion (0.02% of GDP!), while credit market instrument holdings increased an annualized $1.16 trillion. Second, the net investment position of the United States (assets minus liabilities) has increased from -$2.1 trillion in 1998 to the current -$5.2 trillion. Our net indebtedness is now 45% of GDP.

The Fed is all set to tighten monetary policy in an economy extraordinarily dependent on speculative capital inflows, extraordinarily dependent on mortgage borrowing to finance consumption, and with an extraordinarily bloated, extraordinarily interest-rate dependent financial sector driving the economy. (Over 40% of S&P 500 earnings came from financial companies in the third quarter 2003).

I'm amazed how long these economic distortions have lasted, but in retrospect I should have known the powers that be have a survival instinct, and will work ceaselessly to perpetuate imbalances when the alternative is unthinkable. So now I wait for the next economic slowdown, which could come much quicker than we expect as the Fed begins to raise interest rates, when all the credit issues that have been papered over come back with fresh fury.

The weakest link over the coming months is the dollar, which has put in only a mild correction despite better fundamental news (higher GDP growth and higher interest rates offsetting higher inflation and larger trade deficit). It took a tremendous effort by East Asian central banks to stabilize their currencies against the dollar last year, and in a global inflationary environment these are resources badly needed elsewhere.

Protecting the currency means the Fed might have to tighten quicker and faster than they wish, and with an election and the return of "global uncertainties" this means more volatility in markets than speculators would wish. The rest of 2004 will be very interesting.

posted by Teddy | 7:00 AM |
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