June 17, 2006

Sorry, this Update is a little long and come closely on the heals of the last one.  However, I have had a number of people email me asking similar questions, so I hope this Update has some useful information.

Over the past few weeks we have seen the Dow loose all of it gains for the year but then bounce back over 11,000.  The media is full of stories about the bursting of the housing asset bubble.  The yield curve in the U.S. is inverted.  Stock markets from across the globe are falling.  Emerging market stock markets in particular are plummeting.  Are we headed for a worldwide recession?

As with issues in economics, the truth is not nearly as sensational as the popular press makes them out to be.  Let’s step back for a moment and take a closer look at what is going on.

Excess Liquidity

Over the past several years global markets have been awash in excess funds.  Back when Ben Bernanke when was “just” another Fed governor labeled this a “global savings glut.”  Basically central banks had allowed liquidity to increase in financial markets (in part response to financial crises) and since this excess liquidity did not trigger higher inflationary expectations but instead led to increase American spending, the decided to “let it roll.”

Some argue this excess liquidity actually helped trigger asset bubbles around the world, we can discuss that later.  What the excess liquidity did for certain is that it allowed the Fed to cut short term rates to levels we hadn’t seen since the Eisenhower Administration.  Thanks to those low interest rates and increased home prices, American households borrowed (especially against the equity in their homes) and spent.  This spending helped to drive the U.S. economy and much of the world economy.  As returns on safe assets like U.S. Treasuries were very low, financial market participants started to seek out higher returns and thus were attracted to more risky markets.  The excess capital sloshed around the world and the U.S. consumers spent and spent.  Alan Greenspan went off to retirement a virtual economic god.

Ben Bernanke took over Greenspan’s spot at the Fed and financial markets shot him a dirty look.  It must hard to replace a legend.  Ben Bernanke meet Scott Hunter (sorry for the obscure Green Bay Packer reference:  Scott Hunter replaced legendary Packer quarterback Bart Starr…and…well, let’s just say Hunter never felt the love).

The financial press was full of stories that Bernanke was soft on inflation.  Bernanke favored an explicit inflation target.  “Nice in theory Benny but this is reality” the financial press seemed to be saying.  The financial markets too started to worry that Bernanke would not be as tough on inflation as Greenspan had been.

Bernanke understands very well the role of expectations and central banker reputation.  He did not want to become the American Wim Duisenberg.  So Bernanke went on the offensive.  He started talking tough on inflation and continued with Greenspan’s tightening.

Financial Markets Goldie Locks.

As the American tightening continued the European and Japanese economies started to FINALLY show some signs of life.  But with these signs of life came growing concerns of inflation.  So, the European Central Bank and the Bank of Japan did the intelligent thing and started to either tighten and/or talk about tightening.

Now the financial press switched to worrying about “excess tightening.”  The Goldie Locks in the financial press and market that first thought Bernanke was too loose now they find him to be too tight.  Would these higher interest rates choke off the U.S. expansion, financial markets began to worry.  If so what would this mean for equity prices in the U.S?  What would this mean for “more risky” markets?  That answer was clear:  sell!  Sell U.S. equities, sell emerging market equities, sell anything that had an risk to it at all. 

Again Bernanke knows the importance of expectations and he responds.  He starts talking about how the U.S. rate of inflation really isn’t that bad…really.

As Bernanke and the rest of Fed start to talk about the core inflation rate really not being that bad, the equity markets bounce back.  Okay, markets seem to be saying, maybe things won’t be so bad.  The markets still fully expect that the Fed will increase rates again at the end of the month when the FOMC next meets.                                   

So what are the prospects?

The reason why the Fed is tightening is, in great part, due to fears that the U.S. economy had been growth too quickly.  It’s a nice problem to have.  But, many argue, there are a lot of market participants who have never experienced a Fed tightening, and they are “freaking out.” 

Many current market participants are used to seeing the Fed either cut rates or leave them unchanged.  They are not used to seeing the Fed continually raise rates.  Those of us who are old enough remember the early 1980’s…now that was a contractionary monetary policy!  This is more a return to normalcy.

In addition, the rest of the world is finally starting to grow.  This is good news.  The U.S. can not and should not be expected to be the sole engine of global economic growth.  It is nice to see the Japanese and possibly the Europeans (as well as Latin America) are joining in on the fun.  As these other big economies growth that will help our economy and help the rest of the world.  As the rest of world grows they will buy more of the goods and services we produce, so we too will benefit.  Globalization can be a prosperous circle.

But for every action there are reactions.  As the rest of the world grows and finds profitable investments at home, foreigners may not be as willing to continue to bring massive amounts of their savings to the U.S. markets.  Therefore if the U.S. federal government doesn’t get its budget deficits under control U.S. interest rates are going to have to increase further to continue to attract capital.  This will mean the cost of capital to our firms will be higher than what it really should be.  This will have a unnecessary drain on our rate of economic growth.

Does this mean that the dollar will plunge into a free fall as some left-leaning financial types suggest?  Again, reality is not so dramatic.  The dollar may continue to loose value, but that will help U.S. exporters.  Also the Japanese and Europeans are not stupid.  They realize that one of the reasons why their economies are growing is thanks to exports to the U.S.  A big drop in the dollar is not in their interest.  Plus as the dollar drops, FDI in the U.S. starts to look like a bargain to our foreign friends.

This is not to say the United States has nothing to worry about.  The federal budget deficit is an immediate concern as is the low U.S. savings rate.  Housing prices look to be moderating so those who gambled on real estate are probably going to be big losers.  There are also concerns over the quality of skills of the U.S. labor market.

Will these problems result in an economic meltdown for the United States?  No probably not.  Instead look for the U.S. economy to grow around 3-3.5%, with only moderate inflation, and a falling current account deficit.  All of this, of course, with the caveat that economists are horrible at predicting the future. 

All the best,

MBrandl