Really it doesn’t seem to be such a big deal, to add or not to add (0.25% to the Federal Reserve’s overnight funds rate), and in some ways probably it isn’t. But at the same time I can’t help feeling that Sir Alan faces tomorrow one of the most difficult decisions of his whole term at the Federal reserve.
In fact the problem isn’t the quarter point rise, but the vision of the future movement of US interest rates that the Fed will offer tomorrow. A quarter point more or a quarter point less isn’t going to make or break any sophistocated economy (and anyway the important issue is going to be what is termed the yield spread, crudely the difference between the overnight funds rate and the rate on five and ten year US Treasury bonds, a measure which gives a lot more accurate picture of what people will have to pay to borrow money). Ideally Greenspan shouldn’t raise the rate at all tomorrow, but he has now probably boxed himself in too tightly to have the benefit of this leeway. Beyond this he needs to give a clear indication that there will not be any need for a vigorous raising of rates, not now, and not for some time to come.
The issue tomorrow essentially goes back to decision at the June meeting to start raising rates again. I feel this was a bad decision. It was a bad decision because it was bowing to pressure from financial markets for a rise. Essentially the continuing restraint on the part of Greenspan, Bernanke and co, just wasn’t being understood. The situation was a complex one, but the message wasn’t getting across. In trying to ‘talk up’ the markets, Greenspan effectively talked himself into a corner, a corner from which he now has to try and extract himself.
Ideally, given the complexity of the situation, there were good reasons to wait till the autumn before starting any move (and whatever the total reasoning pack behind June’s decision, political pressures must have undoubtedly been there: it is hard to imagine the tightening process really getting going in the run-in to Presidential election, with all the controversy this would inevitably have created).
What then are the issues which should be in the forefront of Greenspan’s mind tomorrow. In the first place there is ongoing geopolitical instability: but you try explaining that to the markets without provoking panic moves. Then there is the extent to which global growth is dependent on a very undependable Chinese economy.
Then there is the question of inflation, which is generally a red herring here. The present bout of inflation is a result of the pressure on global raw material resources produced by what is essentially good news: some parts of the developing global economy is actually developing faster than before. But supply of some key raw materials is limited, hence the pressure on prices.
But more than a new inflation spiral (I continue to maintain that the overal global tonic is deflationary, with productivity gains and capacity increases outstripping the secular rise in demand), what this represents is a change in the terms of trade. Those countries relatively rich in resources will benefit, and those which are ‘resource light’ will have to pay more to get the same. In this latter group are not only the majority of the OECD countries, but also some important new players like India and China.
In the OECD case the implications are obvious: a relatively lower standard of living. This is plain, even if the politicians choose not to explain it. In the case of India and China it presents an almost ‘natural’ brake on the development process.
In fact the movement in oil prices can itself be seen in this light, as a kind of automatic stabiliser/brake. As global growth accelerates oil prices rocket, then as people inevitably price in the additional cost of oil (and other key resource commodities) growth expectations themselves come down, which ultimately reduces the pressures on commodity prices. Of course the geopolitical ‘wild cards’ (Iraq, S Arabia, Yukos, Venezuela) have their part to play in the story, but the essential underlying story is the stabiliser/brake one.
What is clear already is that this process is very different from the 1970’s. We are simply not going to see a wage/price explosion. This is evident once you strip out the so called ‘volatile’ components of food and energy from the basic consumer price indexes. This is well known to Greenspan/Bernanke, and up to June they were defending their position fairly well.
It is also evident that there is no wage ‘explosion’ (except maybe in the sensitive Indian BPO sector). Rather, as we have already been commenting on AFOE earlier this week, the pressure on wages is downwards, as large numbers of comparatively well educated and capable workers in the third world join the global labour market.
Also there are the internal dynamics of the US economy itself. As is by now (I hope 🙂 ) well known there is a fundamental demographic difference between the US and the EU. Massive inward migration to the US from the late 1980’s onwards has meant that there are some extremely large cohorts queueing up to enter the labour market (the skill levels and educational needs of these cohorts is another question). In order just to assimilate these new entrants the US economy needs to have a relatively higher ‘speed level’: 3 % is a popular consensus number. Failing this the US will be running below speed, carrying what is known as an output gap. The consequences of this gap: downward pressure on prices.
There is an additional factor which may be hard to quantify, but seems as if it might be important. The growing services dependence of the US economy. In parsing the economic numbers a great deal of attention is paid to the performance of the industrial sector, but with each up and down of the business cycle this is really of diminishing importance for the economy as a whole. It is the services sector which is the key.
And in economic terms what is the key difference between the services sector and the industrial sector. Well the services sector is more dependent on human capital for a starter. This might well seem obvious, but the economic consequences may be far from being so.
Richard Berner (Stephen Roach’s optimistic doppleganger over at Morgan Stanley) had an interesting and revealing piece in the forum last Friday. It was entitled “What Will Corporate America Do with the Cash?”. Essentially the point is that the US economy is swimming in liquidity. Ever since 2000 everyone has been waiting for the investment driven boom to arrive. But will it ever? At least as people frame the question.
There?s no mistaking the fact that cash on the balance sheet and corporate cash flow are both soaring. The Federal Reserve?s flow of funds and other data confirm that liquidity is high: According to the Fed, the ratio of liquid assets to short-term liabilities ? the so-called ?quick ratio? ? at nonfinancial corporations at the end of March stood at 38.6%. That?s up 12 percentage points in the past four years to the highest level since the 1960s (the ratio also reflects ongoing declines in short-term borrowing, as both bank and CP borrowing have been falling for three straight years, but the ratio of cash/corporate GDP is similarly at a 40-year high). Courtesy of Corporate America?s ability to exploit the operating leverage in their businesses, a tailwind from the dollar?s decline, and falling interest expense, cash flow has also skyrocketed. Notwithstanding recent downward revisions to corporate profits data in the National Income and Product Accounts (NIPAs), the explosion in earnings and margins has brought corporate operating cash flow (based on the so-called ?economic? profits measure in the NIPAs) to 16.3% of corporate GDP, an all-time record.
Meanwhile, capex and inventory accumulation have rebounded. Over the past year, for example, the nominal growth in capex of 10.8% exceeds the average growth rate in the second half of the 1990s by 200 bp. And companies have swung from inventory liquidation to accumulation in the past nine months. But the sum of these two financing needs stands well below their peak in 2000 in absolute terms. Combining these two trends, the so-called financing gap ? the difference between cash flow on one hand and the sum of capex and inventory accumulation on the other ? has been in negative territory for the first time since 1975, and we estimate that the gap remained below zero for a record five straight quarters. That excess free cash flow has been the primary contributor to corporate cash hoards.
In my view, however, companies are not truly hoarding cash; rather, they are swimming in it.
Taking Berner’s argument at face value, it seems that corporate America simply does not know what to do with the cash. Now this may be more than simply lack of imagination. There may well be solid underlying and structural explanations for this.
Add to it the fact that in the years 1998-2000 something like 50% of gross fixed capital formation was in computers and equipment (and nearly 50% of this in software) and you can see there may be a problem. In principal what you need more than ever before are people, and the main complement you need for these people comes from a sector where Moore’s Law and other similar phenomena operate (ie you constantly get more for less – no pun intended). So the big problem is what to do with all the money.
All in all then this is a very complex situation. As I said at the start, the problem is not a quater point more or a quater point less, the problem is one of shifting market expectations away from a simplistic ‘yahoo’ (again no pun) mentality, to one which takes on board this complexity, which doesn’t see the inflation demon waiting round every corner, and which doesn’t imagine 2004 – 2010 will be a simple re-run of 1994 – 2000. Good luck Sir Alan.