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Economics Weekly - Will US monetary policy become ineffective? Weekly economic data preview - Bank of England to cut interest rates, ECB on hold
Economics Weekly 4 February 2008
Will US monetary policy become ineffective?
Recent Fed action has been aggressive...
The US Fed is cutting interest rates sharply, fearful of recession and the fallout from the credit market crisis. The US government has also enacted a fiscal stimulus package worth $150bn, or 1.1% of gdp, which will take the budget deficit to 2.4% of the economy in 2008. All of these measures have one thing in common; they are trying to stimulate demand in an economy that has been growing above its long run potential for almost the last decade, and with a much wider current account deficit in consequence. But will these policies prevent economic slowdown and solve the credit market problems, triggered by the bursting of the housing market bubble? The jury is out on this as far as we are concerned for a number of worrying reasons.
...but the US economy has significant imbalances
A slowdown in the US economy was and is necessary because of the huge imbalances that had developed in the US and are still in place, see chart a. The key reason is that demand in the US has been kept too strong, by low interest rates and a loose fiscal policy. This has resulted in US households and government saving too little and by extension consuming too much. In fact, they are net borrowers, from the US corporate sector and the rest of the world, reflected in a large current account deficit that has to be financed by an inflow of money from overseas, as measured by a capital account surplus. The current account deficit implies pent up inflation, which was only kept modest because of the inflow of goods from abroad. What also helped keep price inflation at bay was a relatively strong currency. But this is now all about to change. Global inflation is rising and money supply is strong (see chart b), as a result of strong growth and the unstoppable industrialisation of countries such as India and China that have a combined population of 2.45bn and this is putting upward pressure on commodities like food, oil and metals. Lower interest rates are making the dollar less attractive to hold. And a falling dollar will exacerbate inflation trends, particularly in the US where lower interest rates may not help the economy much but could increase inflation expectations, so making more likely higher actual inflation later on.
Credit bubble has burst - solution does not lie in interest rate cuts alone
Our view is that the credit crisis in the US and the bursting of the housing bubble cannot be reversed by interest rates. The US is suffering from an oversupply of residential property relative to demand. There is no option but for a fall in prices, as demand cannot be raised sufficiently to mop up the excess of inventories. The link between housing and credit markets was down to loose policy, which led to too much money in the economy and in consequence asset price inflation. This was reflected in newly created composite credit instruments, but was largely driven by the rise in housing related sub prime loans that were then packaged into instruments that yielded higher returns for investors.
Our view is that the regulatory authorities should really have spotted this and acted to put some order around it. These instruments, being new, had and have no common pricing methodology for valuing them that is accepted by all in the markets. Moreover, the credit ratings placed on them by the rating agencies were incorrect given their riskiness (as shown by the rise in defaults in the sub prime components and their current significant downgrades), the result is that the value of these credit instruments has plummeted and is still largely unknown, with the liabilities of the insurers and other holders uncertain. As a result, the wider securities market remains in grave difficulty and some instruments may never return. Although interbank rates have recently fallen back sharply relative to official rates, chart c, financial turmoil persists in equities, currencies and bonds. And credit spreads are wider now than when the credit market bubble first burst in August last year, see chart d. This can only be resolved by full disclosure of positions by all concerned and a bringing of liabilities onto balance sheets, with additional capital where necessary.
The interest rate weapon therefore cannot solve these problems alone. It can mitigate its consequences, but this risks pump priming an economy that has already suffered from too loose policies in the recent past. This is the danger that the Fed now runs. Indeed, it is even worse than this in the long run because, if rates are cut too much, the Fed will lose the capacity and power to influence events. In that situation, the possible negative outcome for the US and global economy becomes much worse. In the interim, inflation may well have become embedded into the economy due to loose policy, and the future action taken to restore fiscal and monetary discipline becomes more draconian.
US monetary and fiscal policy may already be too loose
The US authorities may seemingly have room for fiscal manoeuvre, but it is only a small window of opportunity. Adjusted for the economic cycle, which gives the structural position, the US is still running a budget deficit, so the room to increase public spending is not that great. Moreover, with social security payments on health likely to rise rapidly as a share of gdp from 2012 onwards, the US has to run a significant fiscal surplus soon. So the bigger the budget deficit it runs today, the more wrenching the turnaround will likely have to be in the years ahead. This is more likely to be the case if the Fed cuts interest rates too low, so that they cannot be reduced in the future to stimulate the economy, given inflation risks. With this in mind, the Fed may have to be very careful about further cuts in rates as many now demand, despite the seeming room it has. These risks are highlighted in the facts that money supply growth is still strong and the Fed is cutting rates even though inflation is rising, see charts e & f.
To reiterate, given the imbalances in the US economy, cutting rates is not the whole solution, as these imbalances will start to worsen from an already poor position even if the Fed is successful in the short term. We believe that the US will avoid recession, but that growth will be weak, around 1-2%. Further Fed cuts risk stoking inflation, and not restarting the credit markets or solving the housing market collapse. The Fed may have to wait to see what effect the recent cuts have had on the economy before deciding whether further action is necessary, and risk disappointing financial markets, but it does look as if rates of 2 - 2.5% are on the cards in the months ahead.
Trevor Williams, Chief Economist
W/c 4 February 2008
Weekly economic data preview
Bank of England to cut interest rates, ECB on hold
The Bank of England (BoE) is forecast on Thursday to cut interest rates as the bank responds to the coming economic slowdown in the UK. Concerns that inflation could accelerate back to 3.0% means the rate cut is likely to be limited to 0.25%. This will bring base rate down to 5.25%, following a cut to 5.5% in December. By contrast, we expect the European Central Bank (ECB) to keep interest rates on hold at 4.0%. Above target inflation and signs of stable economic activity mean the bank is likely to stick to its hawkish stance and warn against inflationary wage settlements. Rising inflation pressures and sustained economic growth are forecast to lead the Australian central bank to raise interest rates by 0.25% to 7.0%. The election primaries on 'Super Tuesday' will overshadow the economic calendar in the US, where several members of the Fed are scheduled to comment on the economy. G7 finance ministers will meet at the end of the week in Tokyo.
â€¢ The BoE MPC is forecast to vote unanimously to cut interest rates to 5.25% on Thursday as it considers the prospects for weaker economic growth this year and continued financial market turmoil. Reports last week of a decline in mortgage activity in December to levels last seen at the end of the 90's and a drop in the manufacturing PMI in January to the lowest level since August 2005 will have reinforced the downside risks to growth the MPC alluded to a few weeks ago in the minutes of the January meeting. BoE governor King in a speech on January 22nd appeared to back the case for lower rates when he declared that 'tighter credit conditions will in the short run slow economic activity, possibly quite sharply'. How fast growth is slowing in the services sector at the start of 2008 will be revealed in the services PMI on Tuesday, and this will undoubtedly feature prominently in the two-day MPC debate. However, broad based concerns that inflation could again take off and rise towards 3.0% as utility prices surge will limit the bank's room for manoeuvre. Our Lloyds Consumer Barometer shows that household expectations of inflation in 12 months time rose sharply in January to 3.1% (full details of the Barometer will be published on Tuesday). Whilst the BoE's updated inflation and growth forecasts will not be published until next week in the Inflation Report, its projections will be pivotal in the rate debate this week and the policy trajectory for the months ahead. Also on the UK agenda this week are releases of industrial output and house prices. We expect industrial output to have expanded by 0.2% in December. The decline in mortgage approvals in December to 73,000, the lowest since 1999, suggests that house prices are likely to show further monthly falls in the near term.
â€¢ A relatively quiet week lies ahead in the US and this means that speeches by members of the Fed will be closely scrutinised for their comments on the economy and the central bank's dramatic 1.25% reduction in interest rates to 3.0% in eight days. Weaker than expected employment data was released last Friday and suggested that economic activity may be slowing at the start of the year. Declines in weekly wage growth and hours worked per week indicated that demand is stuttering. However, the resulting decline in capacity utilisation rates should help to keep a lid on wage inflation. This will be tested by the preliminary releases of Q4 non-farm productivity and unit labour costs on Tuesday, which are forecast to reveal a deteriorating inflation backdrop.
â€¢ The outlook is that the ECB will keep interest rates on hold at 4.0% on Thursday. This was reinforced last week after euro zone CPI for December was revised up to 3.2% from 3.1%. The press conference last month made clear that the ECB's monetary policy is at present being dictated by concerns that the high inflation rate could be used as a tool for employees to negotiate higher wage settlements across the euro zone. Until there is more evidence that this is not the case, the ECB is likely to continue to talk tough and resist demands from market participants to lower interest rates. The euro zone services PMI is due on Tuesday and will show to what extent robust domestic demand is managing to offset the downside pressures on activity from the rise in financial market risk aversion and weaker global demand. In this environment, only the credit crisis is likely to prevent the ECB from raising rates.
Kenneth Broux, Economist
Lloyds TSB Bank,
London EC3R 8BQ
0207 283 - 1000
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