The Hindu Business Line : Fed monetary policy stance

The Federal Reserve may tighten monetary policy by about 50 basis points and not 125, as the market is discounting. There cannot be a repeat of 1994, when US household debt was low, the Federal budget had been turned around, and no labour market arbitrage was available from developing economies. The inflation demon has been slayed. Now, to raise interest rates would be to give life to the demon of deflation, says V. Anantha Nageswaran.

IN THE last few weeks, officials at the Federal Reserve have become increasingly strident in calling for a shift in the monetary policy stance. The Fed Chief, Dr Alan Greenspan, spoke of his determination to fight inflation.

Now, a rate hike in the June meeting of the Federal Reserve is a virtual certainty. In reaction to these comments, the yield on the US 10-year Treasury note climbed and the interest rate futures market has now priced in 125 basis points (Chart 1) of interest rate hikes by the end of the year.

After appearing to weaken, the US dollar had become firmer against the euro, other currencies and gold.

Besides these comments by Federal Reserve officials, was there any additional reason for the futures contract to become more certain about the Fed tightening rates by 125 basis points in the next six months?

The Mortgage Refinancing Application Index collapsed to a new multi-year low (Chart 2) and the ABC-Moneyline poll of consumer confidence was worse than expected. This certainly was not an excuse to raise interest rate expectations but to temper them. Yet, the market had reacted otherwise.

This is fundamentally unjustified and, hence, unlikely to be sustained. If the US consumer, hemmed in by uncertainties on the wages front (note that jobs are getting created in low-wage and not high-wage jobs), on fuel costs and on interest rates, then their spending habits would be reined in, at least temporarily.

With both fiscal (budget deficits are too high) and monetary policy (interest rates are already too low) at the limits of their expansion potential in the US, the economic expansion would collapse if the Federal Reserve raises interest rates as much as the futures market is currently discounting.

The corporate sector is neither investing nor hiring with gusto despite what we hear from talking heads. New Orders for durable goods (ex-defence and ex-aircraft) have picked up recently but are still well below the levels seen during the peak of economic expansion in 1999-2000. The Industrial Production Index is also catching up rather slowly with GDP growth.

In the past economic upswings, industrial production growth had outpaced GDP growth. In this cycle, industrial production has just about caught up with real GDP growth having trailed it until now.

In sum, GDP growth had been led by fiscal expansion and consumer leverage. The growth in household credit market debt outstanding has been parabolic in the last decade (Chart 3). In the last five years alone, it has grown 50 per cent.

Hence, if consumer turns cautious — as he must — then, industrial production and GDP growth would begin to wane. There will be no case for the Federal Reserve to tighten monetary policy as much as the market expects.

Therefore, we reiterate our stance that the Federal Reserve would tighten monetary policy by about 50 basis points this year and not by 125 basis points as the market is discounting. Simply, there cannot be a repeat of 1994. Then, US household debt was low, the Federal budget had been turned around with a tax-increase and spending-cut budget in 1993 and there was no labour market arbitrage available from India, China and other developing economies.

Hence, inflation was bound to rise along with the economic cycle. The inflation demon has been slayed. To go to war against it with higher interest rates would be to bring back alive the demon of deflation that is always lurking around.

Indeed, as HSBC Chief Economist, Mr Stephen King, wrote: "... Cyclically, the arguments in favour of higher interest rates appear to make a lot of sense. Structurally, though, the higher debt levels today suggest we really cannot be sure what will happen when interest rates go up. And because of that, it's just as plausible to argue that initial rate rises could be followed by hurried rate cuts... " (June 1, 2004).

That is why the dollar strength is unlikely to last and hence, the rise of the currency last week is its last hurrah against the euro and gold. A fundamentally sound buy opportunity had just re-emerged in gold.

(The author is Director, Global Economics and Asset Allocation, Credit Suisse. The views are personal. Address feedback to nageswar@singnet.com.sg)

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