The Fed’s Statement — Reading Between the Lines
by Stephen Stamos, professor of economics and international relations, Published in the Sunbury Daily Item, Aug. 17, 2003
On Wednesday, August 12 the FOMC met and decided to leave the Federal Funds Rate unchanged at 1 percent. This was expected.
The real message was in what was said and not said in the Fed's statement. My interpretation is that the economic recovery is not yet on a sustainable path. Economic data is slowly improving, but still mixed. Inflation is very low, prices are weak, and the lack of pricing power does not bode well for long-term earnings or a stronger nominal GDP, which is important for earnings and a stronger equity market.
Indeed, the risk is low; the Fed is still very concerned about deflation. The labor market remains weak and the jobless recovery has now been dubbed the job-loss recovery.
The 2Q03 real GDP of 2.4 percent was largely the result of a one-time defense spending stimulus (otherwise it would have been only 0.7 percent). The strong GDP estimates for the 2H03 and early 2004 (4 percent GDP) are based on a powerful package of lifts that include:
- easy monetary policy of the Fed (low interest rates, money growth, and credit access),
- tax-cut stimulus,
- end of the refinancing boom,
- strong inventory rebuilding, and
- renewed investment spending.
Yet, without any pent-up consumer demand in the economy, the question becomes — what is going to drive sustainable economic growth after the middle of 2004?
Also, earnings at this point in the cycle have been generated from stringent cost-cutting and strong productivity growth (which has made it unnecessary and unattractive for firms to hire labor).
While the Fed attempted to more transparent in its statement, there is much that it did not say that if it did would have cast a dark cloud over the consensus view and undermined the current optimism. The consensus view is that a strong economic recovery is a guarantee, that inflation will be a concern by next year, and that the Fed may be raising rates sooner rather than later. Certainly, the equity and bond markets have been behaving this way.
What was not discussed was equally important. The growing trade and current account deficit will be a powerful drag on economic growth; indeed the stimulus is driving up the US demand for imports. Financing this growing current account deficit along with a growing domestic deficit is going to be difficult for the US in the coming years and put pressure on long-tern interest rates. The US dollar will confront structural pressures to depreciate further, while being lifted near-term by short-term expectations of stronger economic growth in a prolonged low-interest rate environment. Energy prices look to be at high levels for a prolonged period of time (oil at $ 32 per barrel as well as the prospect of high sustained natural gas prices).
The reality for the global economy is for prolonged anemic growth in spite of the nascent economic recovery in Japan. Capital spending while improving has yet to accelerate in a meaningful way. Capacity utilization is at 74 percent and the manufacturing sector continues to struggle with no real help from a weaker dollar. The recent drop in the unemployment rate to 6.2 percent was a fluke and will peak at 6.5 percent and likely stay at that level until the middle of 2004.
With the backup in long-term interest rates, the refinancing boom that has driven consumer spending has come to an end. The housing bubble may show its ugly head if the economy does indeed slow down by the middle of 2004. The combination of the on-going risk of deflation with the progressive integration of China and India into the global economy will continue to challenge the US economy.
The continued uncertainties surrounding the geo-political environment will make any recovery vulnerable and fragile.
Finally, the key question has to be - what will be the US Consumer's response to all of this be? Consumer sentiment and expectations are already showing weakness. In the meantime, the financial talking heads, the administrations economics team, and other economic and financial soothsayers are trying to convince the public and the investment community that the economy is improving and all will be just fine soon.
From my perspective, the equity markets are way ahead of themselves and the bond markets have not really understood the Fed's message. These are not normal economic and financial times. The Fed will be on hold until the end of 2004 (and stands ready to utilize unconventional policy tools if the situation warrants). Fiscal Policy is excessively expansionary with spending, tax cuts, and deficits. Nevertheless, this may not be enough. The 2004 election in the context of this political business cycle will give us plenty to consider in the coming months. Stay tuned.
Steve Stamos may be reached at email@example.com