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OPINION: Ila Patnaik

Few signs of recovery
Business Standard, July 12, 2001

Alan Greenspanís valiant efforts notwithstanding, the US economy is in for trouble

For the last few weeks, I have been at the University of Toronto, and the two things that have struck me are how worried everyone is over the US economy and how quickly data becomes available, the optimism of G-7 finance ministers notwithstanding, to deepen the gloom. In contrast, in India, even bad news is slow in coming.

The latest commerce department figures for the first quarter of the year hold out little hope. GDP growth rate for January-March 2001 was revised downwards to an annual rate of 1.2 per cent. The original estimate was a growth rate of 2 per cent.

This is mainly because manufacturing activity in May declined for the eighth month in a row. It fell by 0.8 per cent. As excess inventories of unsold goods continued to be high, factories cut down on production. And so overall capacity utilisation declined to the lowest level since 1983. Business investment in computers and other equipment fell sharply.

One the one hand, energy prices continued to be high eating into the profitability of corporate profits. On the other, productivity growth declined. As a result, unit labour costs increased at an annual rate of 6.3 per cent in the first quarter, compared to a fall last year during this period of 1.9 per cent. The result was a decline in profitability of US companies which fell sharply in the first quarter.

However, there appears to be some hope on the employment front. For instance, in the second week of June, there was a decline in initial claims for unemployment benefits. The number has fallen for three weeks in a row.

But perhaps the hope it offers is false, because demand for labour continues to decline and the Help-Wanted Advertising Index is nearly a fifth lower than last year. It suggests smaller growth in jobs in the coming months than last year.

Data for the second quarter will be released only at the end of July. But it is widely believed that the economy didnít grow at all in the period April-June. While some analysts estimate growth in the second quarter to be negative, those who believe that it witnessed positive growth put the figure at no more than 0.5 per cent.

Yet, despite all the bad news, it is expected that the American economy will turn around. Faith rests mainly in the American consumer. Consumer confidence actually rose in April. Consumer sentiment surveys both by the University of Michigan and the Conference Board indicated that regardless of the bad news about the economy, consumers were not more pessimistic about the state of the US economy or their own incomes.

As a result, consumer spending remained strong. And, despite fears that the fall in stock prices would have a negative effect on personal wealth and therefore on expenditure, US consumers continue to spend. New home sales increased and orders for durable goods such as automobiles and computers rose.

The policy response to the slowdown has been a sharp cut in interest rates. On January 1, 2001 the Fed rate stood at 6.5 per cent. Six months and six steps later it is 3.75 per cent. Down by 2.75 percentage points!

The latest cut in the Fed rate came two days before the revised GDP numbers and the Federal Reserve chairman Alan Greenspan would have had access to them. Yet in contrast to the earlier five cuts of half a percentage point, this cut was limited to one fourth of a percentage point.

The cut obviously meant that the committee that sets the rate (the Federal Open Market Committee) found that the economy still needs a boost. But significantly, not only is the cut smaller, it is also accompanied by a hint that there may be no more cuts.

The switch in policy from half-point cuts to a quarter-point cut is important. This is because the the cut is perceived to be smaller so that it pre-empts a rise in inflation. At the moment, rising unemployment and spare production capacity will limit wage gains and the ability of employers to pass on higher costs in the form of higher prices.

Even though, at the moment, there are very few signs of a recovery. One might have thought that it is too soon to worry about the inflation that will take place after growth has picked up. But analysts in the US do not find it surprising that the central bank has indicated that it is time to shift gears.

They attribute the change to the possible incipient signs of a recovery seen by the Federal Reserve. This is mainly because of Alan Greenspanís reputation, his reputation as a central banker whose objective is to keep inflation low.

In a lucid story of the Federal Reserve policies during the last decade, Bob Woodward in his book Maestro: Greenspanís Fed and the American Boom, narrates how Greenspan inspired Clintonís deficit reduction targets in 1992.

Greenspan argued that while short-term rates were at 3 per cent, long-term interest rates, which are determined by the market rather than the Fed, are much higher. The gap between the two is the inflation premium.

Long-term lenders demanded a premium because they believed that with the double-digit inflation of the seventies and the expanding budget deficits under Reagan, the money they had invested would be worth less in the future. Since large deficits resulted in higher inflationary expectations, to reduce long-term rates the budget deficit would have to be cut.

Convinced, Clinton set ambitious deficit reduction targets. Very soon long-term interest rates fell. The reduction in long- term interest rates helped increase consumer spending because of the increase in new mortgages and consumer loans. As long-term interest rates dropped, returns on bonds fell and investors moved to the equity market. This helped push up the stock market.

Later in a series of surprise and unpopular moves, Greenspan raised interest rates from February 1994 to February 1995. Within a few months, the Fed rate was hiked from 3 per cent to 6 per cent as a part of his policy of pre-empting inflation though at that time there was no hint of inflation. He believed that the economy was overheating.

Along with Clintonís deficit reduction, the rate cuts and some fine-tuning, the policy gave the US the goldilocks economy. This was one of the longest expansions in US history, with low inflation and low unemployment, lasting 10 years.

The latest quarter point cut will hardly impact the cost of capital. Its purpose is to indicate that the Fed will remain in control of inflation. The intention is not just to have lower short-term rates that are determined by the Fed rate but to keep inflationary expectations down. This would prevent the long-run interest rate from rising.

Will this master stroke have the desired effect? And will the lower short- run and long-run rates boost growth? For the sake of not only US consumers but the world economy and our own exports, one certainly hopes so.

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