Long-term bond rates show few expectations of a pickup in
inflation. Should unforeseen circumstances bring this to pass, it could feed quickly into long-term government rates. This could adversely affect the US housing market, presenting a complex challenge to US and global policymakers.
Ten-year Government bond yields in the United States and Europe have fallen despite signals of higher policy rates from the world's key liquidity provider: the US Federal Reserve.
Key assumptions
Short-term US interest rates will rise to 5% in June 2006. A faster climb seems unlikely, as the 'core' inflation rate dropped in April to its lowest rate since 2003.
Higher real long-term rates are difficult to envision, but would have a serious adverse impact on aggregate demand via a downgrade in personal wealth, on the assumption that house prices would begin falling.
Congress and the White House are at odds over dollar policy, but could unite behind a weaker dollar if the housing market were to soften. If the euro-area fails to enact a policy innovation to support a stronger stimulus to domestic demand, and East Asia does not countenance stronger local
currencies, a third path to US balance could lie in a US recession.
Even with the Fed's latest hike, real short-term interest rates have yet to reach positive territory, let alone 'neutral' territory for an economy growing in excess of 3% per year. This means the Fed will continue pushing the
short-term rate up throughout the coming 12 months. If it does so at the same pace as in the past 12 months, short-term rates at this time next year will be 5%. A faster climb seems unlikely, as the 'core' inflation rate actually dropped in April to its lowest rate since 2003. The fact that energy prices advanced 19%
in the year to April demonstrates the extent to which the economy has decoupled from energy shocks.
Market surprises
Nevertheless, there are scenarios under which long-term rates
could climb again, caught off guard by unanticipated developments:
Inflation. Headline US CPI inflation hit 3.5% in April. Energy is not the only sub-index driving the headline number. Medical care costs rose 5.1% in the three months to April (at an annual rate). Producer prices (excluding energy) have been rising between 6-10% since late 2003.
Credit demand. Current troubles in the euro-area could provide the impetus for a significant reformulation of the Maastricht Treaty to allow a far greater European presence in the global top-tier sovereign credit market. Competition for funds would produce higher long-term US rates.
Real estate. Higher real long-term rates would constrict mortgage credit in the United States and elsewhere. The impact on aggregate demand could be significant. It would be channelled through a downturn in construction activity and a downgrade in personal wealth, on the assumption that
house prices would begin falling.
For the United States, the outcome would be a deceleration in growth, and there could be a challenge in reviving it. The Fed by this point would have re-loaded the 'monetary cannon', with 500 basis points at its disposal. Yet it is unclear
that an interest rate cut would resuscitate the housing market. The Japanese experience, for all its differences, suggests it would not. A second option would be fiscal relaxation, even given the large general government deficit.
However, this too would have uncertain effect. It might only hasten the rise in long-term interest rates.
Dollar policy
This would make dollar competitiveness a hotter topic. Congress
is currently at odds with the White House over the dollar's strength. The latter wants low long-term interest rates to fuel growth via the housing market (arguably, a classic case of excessive reliance on growth in 'non-tradables' in
the presence of an overvalued currency), and Asian support for the US currency is crucial . Congress wants a weaker dollar to support the US tradables sector.
The compiler of the US manufacturing activity index on June 1 announced a marked slowdown, and wondered aloud whether the resilient dollar is "slowly bringing this manufacturing growth cycle to an end."
Under deteriorating domestic conditions, this impasse could yield to a united front:
Export drive
The White House could switch sides if the housing market fell and
was not seen as being easily revived. At that point, dollar adjustment would be the 'actionable' policy variable, and greater pressure from the executive branch would be applied to trading partners to achieve it.
Detroit trouble
The ratings downgrades of Ford and GM debt have produced some 30 billion dollars in capital loss for bondholders, and signal considerable difficulties for the automakers. Though these cannot be solved by a more competitive exchange rate, it would clearly help. Importantly, it is against the currencies of South Korea and Japan that the dollar must fall, rather than
against that of China, upon which Detroit relies for low-cost components imports.
Yet East Asia might acquiesce in only a modest revaluation, and in exchange for a pledge of US and EU market access. Monetary conditions in China -- around whose currency the region's policy turns -- do not necessitate such a move (see
CHINA: Monetary conditions suit RMB-dollar peg - May 17, 2005). Moreover, with 200 million of its own unemployed, Beijing will overlook Detroit's difficulties in its efforts to ensure robust external demand for its own economy.
Demand vacuum. The US corporate sector, too, might be a disappointing source of demand, if other 'bubble' experiences are suitable templates. Japan in the 1980s and the United States in the 1920s both saw smaller financial bubbles than the
1990s US bubble, particularly if real estate is a belated casualty of the stock market bubble (as it was in Japan). Both in Japan and in the earlier US experience, the corporate sector ran a long period of financial balance post-bubble.
For the US economy, that would underline the importance of a weaker dollar. Asian currency intervention is only one of the hindrances to this end. Another is Europe's depressed internal demand. If the euro-area fails to enact a policy innovation to support a stronger stimulus to domestic demand, and East Asia does not countenance stronger local currencies, a third path to US balance could lie in a US recession.
Recession reprise?
The last time the US current account was in persistent
deficit (the 1980s), it was balanced by a recession (1990-91). Real US imports of goods and services fell in 1991 for the first time in a decade, as US exports of goods and services advanced 6.6% year-on-year. The 1980s decline in gross
national savings (as a percent of national output) hit a trough in 1993.
In an optimistic scenario today, a US recession would force East Asia into a greater domestic orientation . That could fit with a US export surplus, with depressed US household consumption freeing up capacity for exports. Commentary
on US industrial 'hollowing out' has been overdone. Many areas of US services, commodities and even manufacturing would be competitive internationally at a more favourable exchange rate. Yet the political economy is vital. This scenario
demands a constructive global public attitude toward open trade, and -- in Europe and East Asia -- tolerance of deficits. The return to US balance at the beginning of the 1990s was accommodated by a dramatic European shift into deficit and, in East Asia, an eight percentage point decline in the current account surplus (as a portion of GDP).
East Asia
A stronger domestic-demand orientation in East Asia seems plausible, either sooner via a revaluation or later via a US recession. This can be sustained by running down these countries' enormous reserves, and would restore developing East Asia (including China) to the international footing it established before the 1997-98 crisis, which ended an extended period of current account deficits .
Europe
Europe's path is problematic. It will compete well with US and Japanese multinationals for Asian market share (another reason why Washington will need a much weaker dollar). Yet this cannot make up for the fact that Europe has not developed a political consensus on growth strategy. The de facto strategy is one inherited from the relatively more benign growth environment of the 1990s, and enshrined in the Stability and Growth Pact (SGP). This is a supply-side strategy which calls for flexibility in labour, financial and product markets.
Demand-side difficulties are virtually ignored:
Households: The supply-side emphasis of reforms is scaring households into higher savings.
Business: The setback in EU governance reform resulting from the French 'No' vote to the EU Constitution raises uncertainty and pushes back the horizon for completion of 'Lisbon Agenda' initiatives.
Policy: The SGP precludes coordinated stimulus -- notwithstanding transgressions already registered. It also arguably makes fiscal expansion more subject to
'Ricardian equivalence', since households might expect fiscal laxity to result in fines or tightening of some kind.
Growth challenge
The global growth challenge could be complex. European stagnation has set in, and options look spare. Across the Atlantic, the May US Purchasing Managers Index at 51.4% -- the lowest reading since mid-2003 -- reflects a discernable slowdown in US manufacturing activity. The PMI jobs index stagnated, ending 18 months of employment growth. Such softening will further encourage the Fed to keep a restrained course -- perhaps even in the face of a
surprise pickup in inflation (to which a weaker dollar would add steam).
An ideal elixir for heavy debt loads, as exist in the personal sector, is unanticipated inflation. The price of Fed discretion would be its inflation-fighting credibility. The bond market would presumably inflict punishment on long-term debt, creating casualties among portfolios rich in such securities and raising the government's debt service burden.
In a favourable scenario, a US slowdown would provide the impetus to push through a new approach in Europe. One option is to tie a bold supply-side reform agenda to a substantial, coordinated fiscal 'kick'. This could be executed outside of the SGP (eg through the European Investment Bank with bond issues guaranteed by euro-area sovereigns) or within the existing institutional framework (eg with 'approved' expenditures not included in calculations of euro-area budget deficits). Such a course would end the historically anomalous present situation in which Washington enjoys preferred access to the global AAA sovereign credit market -- it is relatively little contested by peers in Europe.
In this sense, the European Monetary Union is the best thing that ever happened to US policymakers. Interestingly, the resulting rise in long-term, top-tier sovereign issues and yields might provide exactly the investment vehicles and returns needed for OECD pension funds.
Growth outlook
US professional forecasters surveyed in May expected US growth of 3.5% this year, a 0.2 percentage point markdown from the rate they expected a quarter previous, and a percentage point less than envisioned by the IMF in its April 2005 forecast. Expectations of inflation rates into the medium term confirm the benign inflationary expectations reflected in bond prices. US forecasters in May put annual US inflation over the coming ten years at 2.5% -- unchanged from their estimates made a year ago, despite a rise in current inflation in the interim. Such expectations owe much to the Fed's
inflation-fighting credentials. Arguably, these have yet to be tested in the post-2000 business cycle.
The IMF's April 2005 global forecasts see the EU and Japan growing by 2.5% and 1.9% respectively in 2006. Japan's current account surplus is seen as rising to 3.5% of GDP. The euro-area continues to run a surplus of 0.5% of GDP and the United States a deficit of 5.7% of GDP. Explicit in these forecasts is further strong growth in US final demand, with global imbalances unresolved or worsening. Should it come to pass, a rise in interest rates could produce a slowdown in the US economy, a sharply different composition of global growth, and a difficult transition in the interim.
If a rise in long-term interest rates triggers a fall in US house
prices, a US export boom becomes possible -- in the short term via an Asian revaluation or in the medium term via a US recession. The burden of growth would fall to Europe and East Asia. In the latter, this would restore the region's international footing before the Asia crisis.
The response from Europe is more difficult. The emphasis so far on supply-side reforms is proving unhelpful both in terms of ignoring the demand vacuum and in frightening households. A conceivable, albeit optimistic, scenario envisions a dramatic increase in European government borrowing, tied to an ambitious reform agenda. The danger lies in the alternative: a vacuum in US and euro-area demand stoking calls for state interventionism and protectionism.
By: N. Peter Kramer
