The American Economy: Call it the Teflon Econ

In Washington D.C. the Federal Reserve meets again today to discuss U.S. monetary policy, and if pundits in the financial media are to be believed, the fate of global growth (and liquidity) hangs in the balance.

Of course what takes place in the American economy has huge implications around the globe. Make no mistake, the U.S. remains the world’s engine of economic growth – apparently it’s the little engine that could. That’s because to paraphrase Mark Twain, rumors of the U.S. economy’s demise have been greatly exaggerated – for some time now – call it the Teflon Econ!

• An inflation scare in 2005 (now apparently subsiding) couldn’t stop it …
• A well documented housing collapse didn’t derail it (so far at least) …
• Even record high crude oil prices, and 325 basis points of Fed-induced interest rate hikes -- both at the same time -- just briefly slowed it down.

The American economy has remained resilient throughout. And economists widely believe the Fed will stand pat on monetary policy again today, as they have since last summer. In fact, financial markets are still looking forward to the possibility (with the odds now down to about 25%) that the Fed’s next move will be to cut rates sometime later this year.

Financial markets around the globe owe their buoyancy in recent years to excess (or excessive; take your pick) liquidity sloshing around the world. And the resilient U.S. economy plays no small part in fueling this asset appreciation party. You only have to glance at America’s record trade deficit with China to understand that point.

China’s trade deficit with America widened to a record high US$214 billion in the year 2006 (through November) as China shipped a record US$1 trillion worth of merchandise to American shores – most of it destined for your local Wal-Mart store, or so it seems.

Should the U.S. economy slow more than expected and the resilient American consumer stumble, economic tremors will certainly be felt in Beijing, and Tokyo, and Toronto, and in the EU, etc., etc.

Fortunately, recent tea-leaf readings on the U.S. economy show signs of reaccelerating growth. Retail sales were robust in November and December (see graph above), industrial production is on the rise again after a brief slump, and even real estate shows renewed vigor, with housing starts up the last two months straight.

As a result of this data, the Fed has cautioned us in well choreographed public pronouncements, not to expect lower rates anytime soon. Just a few months ago, Wall Street fortune tellers held a nearly unanimous expectation of a Fed rate cut in the first-half of 2007. It was regarded as a “sure thing” in fact.

Today, Fed funds futures (a sort of book-making operation betting on the direction of short term interest rates) suggest only a 2% chance of the Fed easing before June – and just 1 in 4 odds of a rate cut by September. 

But with overnight interest rates apparently on hold in the U.S. at 5.25% (see graph above) -- among the highest in the developed world – the question is just how restrictive this is to economic growth already.

Headline inflation numbers have been trending downward of late. This means that even if the Fed remains on hold the effective (or “real”) rate of interest borrowers must pay keeps climbing.

For instance, when headline inflation peaked at 4.7% in 2005, with Fed fund rates then at 4%, the “real” rate of interest was effectively zero after subtracting inflation (-0.7% to be exact).

But at the end of December, consumer price inflation dropped to just 2.5% year over year. This means that today’s real interest rate is up to 2.2% -- and will climb still further if inflation continues to trend lower.

Now granted, a 2.2% real rate doesn’t seem too restrictive. But it’s not out of the question for the Fed to reverse field (and surprise financial markets) with an unexpected rate increase down the road, should the U.S. economy rebound faster than expected.

This is the really BIG question … stay tuned.

Comments

[Ames Tiedeman]

Bernanke has a big job ahead of him.
We cannot sustain 800 bilion a year trade deficits. We cannot export our way out of this mess. The only answer is a sharply lower dollar to drive manufactruing home and to lower the trade deficit. The dollar has much farther to fall. What you are seeing is a long term effort (it will take 20 years) to get the trade deficit back under 1% of GDP. We are currently running a trade imbalance of nearly 6% of GDP. No nation can do this. The IMF would be stepping in to help any nation if its trade imbalance went to 6% of GDP becuase its currency would collapse! The U.S. is different, but still, we cannot sustain a trade deficit of this magnitude. People must understand that when we buy an item from say China, we pay in dollars. The Chinese company we just bought from them goes to an Exchange Bank in China and converts those dollars to Yuan. The Chinese banking system (Chinese Government) is now sitting on those dollars. They can either 1, buy oil, 2, buy Treasuries, 3. buy U.S goods, 4. buy U.S. Corporations, 5. other. Over time if we (the U.S. ) continue to run a trade deficit we could simply be completely bought and controlled by foreigners. Warren Buffet has explained the situation as being like a rich Texas farmer who loses a small piece of his land year after year and never notices for a while. When he then notices, tragedy sets in because he no longer controls his land. So in sum, we need to get the trade deficit way down. This is why the Fed has abandoned the dollar. It wil be going down for the next 20 years. That is how long it is going to take to correct this imbalance mess.