Stephen King: World has stopped dancing to America's tune
Monday, 2 April 2007
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Let me make a few observations about the US economy. Inflation is rising. The housing market is declining. The current account deficit is narrowing. And there is a strong whiff of protectionism.
These developments are, collectively, distinctly unhelpful. They provide seemingly inconsistent messages about the health of the US economy, and they say little about the Federal Reserve's next move on interest rates. They may, however, be saying something about America's changing relationship with the rest of the world.
As Ben Bernanke, the Federal Reserve's chairman, reminded Congress last week, inflation certainly isn't dead. Yet, despite these price pressures, the Fed must also be feeling distinctly uncomfortable about the performance of the housing market.
The only good news is coming from America's balance of payments position, where, for the first time in ages, the deficit is beginning to shrink, helped along by a boom in activity elsewhere in the world, notably from within the emerging markets.
Yet, just at the point when the current account deficit is improving, the US Commerce Department has decided to raise the stakes in its battle against "unfair" competition elsewhere in the world. On Friday, it chose to impose tariffs (sorry, "duties") on China because Chinese manufacturers of coated paper have, apparently, been subsidised in ways that will drive out American competition.
These developments point to a period of intense soul-searching for US citizens and policymakers. Consider how things have changed in just the past 10 years. During the late 1990s, the US economy reigned supreme, outperforming most other economies and leading the way with new technologies. While emerging markets collapsed under the weight of the Asian crisis and the Russian debt default, the US economy sailed serenely on. Growth was strong, inflation was low, and people were rich. The current account deficit was a symbol of American success, a sure sign that the US was the world's favourite destination for excess savings.
A decade later, and things don't look quite so encouraging. Growth is now a lot slower. Inflation is stickier. US stocks have risen, but have underperformed stock markets elsewhere. The US is heavily indebted to China, Russia and the Middle East. And the rest of the world seems to be doing so much better.
It's this success elsewhere in the world that is, I'd suggest, causing the US so many problems.
Over the past few years, the Federal Reserve has raised US interest rates from a trough of 1 per cent to the current level of 5.25 per cent. This hairshirt strategy has started to work. How else can the current severe weakness in the housing market be explained? If the earlier housing boom was very much a product of unusually low interest rates which stimulated the growth of so-called adjustable rate mortgages (ARMs), it follows that the collapse over the past year or so is probably a response to the return of more normal levels of interest rates. ARMs no longer look quite so attractive.
With a weak housing market, why not now cut interest rates? That, after all, was the reaction of the Federal Reserve at the beginning of 2001 after a number of months of stock market declines. Housing, surely, deserves the same treatment.
While this conclusion seems obvious, there is one major problem. Inflation in the US is still rather elevated. Mr Bernanke has often argued in favour of achieving an inflation rate of between 1 and 2 per cent. The latest readings, though, show a 2.4 per cent increase in the core consumers' expenditure deflator - the Fed's favourite measure of inflation, one that excludes food and energy prices - high enough to make the Fed think twice before responding to the persistently disappointing news in the housing market.
Inflation has been a lot stickier than the Fed had expected. One reason for this, I suspect, is the influence of developments elsewhere in the world. Back in the late 1990s, the merest hint of rate increases from the Federal Reserve was typically enough to send emerging markets into traumatic convulsions. Having built up large current account deficits, emerging markets needed US interest rates to stay low to ensure continued funding of those deficits: as soon as US rates went up, the funding tap was turned off, and the only way to balance the books was a deep recession which lowered imports into emerging markets and, hence, narrowed their current account deficits.
These emerging market crises drove commodity prices lower and the dollar higher. For the US, these developments helped to suppress domestic inflation: emerging market failure meant lower US import prices.
Emerging markets now dance to a different tune. Many of them now have current account surpluses. They're no longer dependent on hot money flows coming from the US. They don't wilt in the face of higher US interest rates. As a result, their demand for commodities remains high and US import prices don't come down. US inflation doesn't so easily go away.
For the US, this is rather bad news. The emerging market safety valve no longer works to limit US inflation and, as a result, the US economy has to do more of its own adjusting to ensure a satisfactory outcome for price stability. This is proving to be a painful process. The housing market continues to decline. Problems in the sub-prime mortgage market are not going away. Profits are showing signs of topping out. And capital spending, often seen to be a bulwark against a softening housing market, is now declining.
The good news is that US unemployment has yet to rise. Without a deterioration in the labour market, it's difficult to see the current slowdown developing into a major crisis which might threaten recession. However, the combination of weak housing and softening capital spending suggests that, later this year, rising unemployment might become a reality.
How would the US react to a worsening labour market? The answer, I think, has to be seen in the context of politics, not economics. Last year's congressional election results may have been dominated by the war in Iraq but, domestically, the biggest single influence on voting decisions appears to have been the performance of the economy and, in particular, the widening gulf between the rich and the rest. Add to these concerns a rising unemployment rate and it wouldn't be surprising to see candidates for next year's presidential election playing the protectionist card: far easier, after all, to blame the Chinese, the Mexicans and the Indians for "stealing" American jobs than to argue that the US economy has to re-tool for our newly globalised world.
Coated paper may not, in itself, prove to be very important. George Bush has dallied with tariffs before, most obviously within the steel sector, and nothing much has come from them. The US has, for the most part, mercifully steered clear of outright protectionism. Yet the winds of change may still be upon us. The US is facing too low a growth rate. Strong growth elsewhere in the world - combined with softer domestic demand - may be lowering America's current account deficit, but it's also leaving US inflation too high. If the US can no longer determine its own economic destiny, it's all too easy for its electorate - and its leaders - to blame others. Protectionism may be wrong, but its supporters know all too well its populist appeal.
Stephen King is managing director of economics at HSBC
