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Thursday July 29, 2004 - 11:45:34 GMT
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Greenspan Growth Story Unstable

Greenspan Growth Story Unstable (FXA)

Just because he says it's so doesn't make it so...Greenspan that is...oh that the June slowdown was a dip and there is no looking back as the economy bursts forth. Sure the US consumer confidence data from July, the first data point for Greenspan validation, was as the Chairman said...June was a temporary slowdown, count on the consumer coming back and jobs growing.

But consumer confidence measures are not always (usually) the best guide to consumer as much as inflation expectations are an accurate guide to future inflation (and interest rates). Everything is subject to change...and at short notice. With households leveraged on debt, firms not far behind, the government entering the crowding out zone on borrowing, stocks heavy and oil prices at a record high, the notion that the economy can grow indefinitely requires a belief that everything will fall into place...a dynamic long-run equilibrium yielding 4% GDP on average and core inflation staying under 2%. Since when has forecasting been that reliable for the Fed much less the financial markets? Was it not the same Greenspan Fed that miss forecast a pick-up in growth in 2002 and employment in 2003?

Greenspan is as good as any at reading data, recalling it, and estimating it. But he does not have a crystal ball. On July 20 he did not know what July payrolls will look like when released early next month (August 06). They may be strong they may not. Markets can live with one month as an aberration not two, though clearly in Greenspan's world (with reason) two months don't make a trend. So there is a lot riding on July payrolls as well as how the Fed handles them. It will have to demonstrate restraint in the event of a super number (north of 375,000) and be downright positive on a soft number (150,000 or less).

Monetary policy in the US is a game of group psychology...shaping household, firm and investor psychology around a highly unpredictable set of data points and exogenous developments (like terrorist attacks, like Yukos oil mandates...). Greenspan is all about managing expectations through surprises/shocks with the aim of smoothing them...neither too hot nor too cold. And the Fed can only do so more or less with market confidence in the Chairman's skill set at high levels.

However, managing expectations in the current environment is not without risk, even for the skilled Greenspan. Structural imbalances could conceivably expose fissures in the growth story that could undermine confidence in the economy and the Fed's ability to get it right. At few other times as today has the risk of exogenous shocks such as terrorist attacks and geopolitical crises ever been higher. Can the Fed manage the economy and expectations around another major terrorist attack (or even a less than major attack)? It has experience from 9-11, but the underlying imbalances of low savings and high debt for households has raised the stakes. Greenspan notes that household balance sheets are strong...relative to net worth (despite little savings and high debt). Why? Many people "own" a home (mortgage plus equity) and it has seen significant appreciation. Net wealth is up. Many households own equities through retirement accounts and prices here are sufficiently high to strengthen net wealth. House prices and stock prices can and do go down. The household balance sheet is vulnerable.

Managing the rise in market rates is critical for the Chairman (managing inflation expectations or asset prices). If rates rise too quickly, much of the cheap source of financing that supports leveraged household debt accumulation and housing affordability could diminish. Perhaps less discussed but no less disturbing is the extent to which the credit market itself is leveraged behind an extended period of near record low in rates and the hunt for yield (manufacture of yield in some cases) via credit derivatives. The Chairman says repeatedly that credit spreads are normal and risk is dispersed, markets have adjusted adequately to higher rates. But this market could turn disorderly in a hurry...or so say many who claim to know the credit derivative market. An illiquid market here is not simply the subject of financial science fiction.

Stock prices in the last week since Greenspan testified in Congress have been anything but enthused by the Chairman's optimism. Could it be that so early in the rate cycle and at a peak in optimism among Fed officials and many market economists over US growth prospects, that the equity market fears higher rates and higher rates faster that it is cutting into earnings growth assumptions? Perhaps. But the stock market rallied on July20 when Greenspan spoke to the Senate Banking Cmte and has since found the upside difficult with the exception of Tuesday this week when consumer confidence lifted stocks (sign stock market welcome stronger economy more than it fears higher rates). Keep in mind too that Greenspan's optimism on the economy and low inflation is in part built on fat corporate profits. But firms are not as nearly confident that fat profits seen in the last three quarters will hold up in the next three quarters...some are guiding expectations down).

And what about cyber terrorism that gets little airplay in financial markets? Spyware, worms, viruses cost the economy billions in lost time and revenue. Bringing down search engines this week with MYDOOM is a small example of a potentially larger problem and risk to the growth scenario that needs more discussion and greater understanding. What business is not dependent to some degree on a functioning internet? And the Ludites who seek to disrupt it are a growing drag on growth and productivity.

Oil prices too pose a growing risk. The change (higher) is not proving to be transitory. Sure in 1970 dollars the cost of gasoline is very low and household consumption of petroleum is down. But with the economy running like a unicyclist along a mountain footpath, it does not take much to knock it off course. Between risks to consumption through higher rates (impacting asset prices, debt service and refinancing) sustained high in oil prices poses a significant risk to the Greenspan growth story.

China's attempt to slow its raging economy also bears watching not only a source for cheap manufactured imports but also as a destination for a growing number of US produced goods and services.

I can hear you saying...lighten up. I'll try. Greenspan's optimism could indeed prove justified and my worries just unwarranted anxiety. The economy could just as easily avoid the pitfalls I have listed and stay on the Greenspan track...low inflation, solid growth and job creation. This is not unlike the saddle path solution to the dynamic equilibrium problem in physics (and applied to economic modeling by Dornbusch among others). Any variation from the saddle path and the stability is gone and it is into positive or negative infinity. Okay a bit overstated, but I for one am not so confident about riding this business cycle out along the Greenspan saddle path.

David Gilmore


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