THE ECONOMY

America must avoid a return to the 1970s



It is not every day that Wall Street’s finest appear so bitterly divided about the prospects for the American economy. Equity investors are celebrating their best quarter in 12 years and the Dow came within a whisker of beating its record high last week. With all three main stock indices up around 5% in just three months, casual observers would be forgiven for thinking that America is undergoing a massive economic boom. Bond traders, by contrast, as well as most economists, are gloomy. The fixed income markets have priced in a hard landing with the leading scenario being of a slump in house prices that will hit consumer spending and hence growth. The price of US Treasuries has been going up since late June, while yields have been falling, as analysts have come to believe that the Federal Reserve will not need to raise interest rates any further.
This apparent gulf between bulls and bears is exaggerated. Nobody sensible – and that does include equity investors – would deny any longer that the American economy has slowed and that the housing market has finally ground to a halt. But this does not yet mean that share prices should be falling. What has confused many commentators is that several concurrent forces have pushed up share prices despite the economic downturn.

First and least-well understood, is that the lower long-term interest rates caused by the mounting fears of an even sharper downturn have also cut discount rates in stock valuation models, hence made shares look more attractive. Share prices have benefited from one of the self-regulating mechanisms which always help a market economy recover in bad times. At the same time, mergers and acquisitions continue to boom, pushing up share prices of target firms, thanks in large measure to the continuing influx of private equity cash; and the sharp decline in the price of oil has delivered consumers a fillip, cut input costs for manufacturers and cushioned the impact of the housing slowdown.

Equally important is that in the age of globalisation corporate profits and hence share prices are increasingly disconnected from any one economy. As luck has it, the American and global economies have decoupled since the start of the year: growth in Asia remains extremely strong and even though the euro zone’s mini-spurt has already largely come to an end, growth in Europe remains reasonable. Thanks to their vast and ever growing international operations, American companies are continuing to cash in on this global growth, even though many are understandably growing nervous about the situation at home.

The American economy, while undoubtedly in its most fragile state since 2001, is not yet in crisis and the probability that it will tip into recession at any point over the next 12 months remains low (though certainly not as remote as a few months ago, when the chances were close to zero). The latest data has been relatively encouraging. The University of Michigan’s consumer confidence gauge rose to 85.4 last week; the Chicago Purchasing Managers’ business index rose to 62.1 for September. Personal income rose 0.3% in August compared with July, quite a good result, though down from the 0.5% rise seen the previous month. Personal consumption inched up 0.1%, partly thanks to a still negative savings rate. Two of the weakest areas for the American economy are house prices and car sales. Sales of new homes priced over $300,000 have crashed by between 25% and 36% over the past year, while those priced up to $300,000 declined by 14% to 19%, according to Morgan Stanley. On some measures, house prices are now already falling in dollar terms for the first time on record; they are dropping on all measures in some of the most overheated local markets.

Partly as a result of much higher petrol prices in the first half of the year, car sales are also declining quite sharply. The moving 12-month average of seasonally-adjusted unit sales of cars and light trucks calculated by Moody’s sank by 5.3% annually in August 2006, the deepest decline since the 5.7% drop suffered in September 2001 after the terror attacks.?We are not yet in recession territory. During 1990-1991, the decline bottomed at 11.3% in November 1991; during 1980-1982, it fell -20.3% in January 1981. The recent sharp drop in oil and petrol prices is likely to reduce the pressure on car makers over the next few months but it will not save what is left of America’s home grown car industry. January-August 2006’s 3.4% year-on-year collapse in car sales was accompanied by a stunning 12.4% surge in imports and a 7.2% decline in sales of US-built models, with cars built by Japanese manufacturers in America relatively unscathed.
The trouble for the US economy is that there is no easy way out of its conundrum. After the collapse of the dotcom bubble, Alan Greenspan, the former Federal Reserve chairman, slashed interest rates; his aim was to pull the American economy out of the bust without having to endure a massive recession and even deflation. The result was a massive house price bubble and consumer spending binge as the cost of borrowing tumbled; Mr Greenspan knew that there would inevitably be a day of reckoning, but felt that he had no choice.

In the end, monetary tightening and the normalisation of interest rates under Mr Greenspan and his successor Ben Bernanke came too late: thanks to the huge amounts of liquidity injected into the economy, price pressures moved from asset markets to consumer prices and inflation became entrenched into the economy once again. Even though economic growth was just 2.6% in the second quarter, inflation is still rising. The key price index for personal consumption expenditures, which excludes food and energy, grew by 2.5% in August, the highest since April 1995.
For the time being, Mr Bernanke should not cut interest rates. The economy may be weakening but it is not tanking; regaining control of inflation is his most pressing task. Mr Bernanke needs to make sure that annual core inflation returns to a more tolerable level of between 1% and 2% before he can even consider easing monetary policy again.

With the mid-term elections approaching, then the start of the presidential campaign early next year, this will not be easy. The last thing America and the world need is higher and higher inflation at a time of weaker growth – when that was last tried it was called stagflation and helped ensure that the 1970s are remembered today as an economic nightmare. Mr Bernanke must keep his nerve and resist the lure of returning to easy money.