2018-12-12 05:22 KST  
Global Voices Online - The world is talking. Are you listening?
U.S. Economy Is Rising, But So Is Its Trade Deficit
[Analysis] Ben Bernanke, the world's most powerful central banker, has a rocky road ahead
Bhuwan Thapaliya (Bhuwan)     Print Article 
Published 2006-04-13 17:26 (KST)   
The U.S. Federal Reserve has raised interest rates 15 times since mid-2004 to the current level of 4.75 percent. The latest quarter of a percentage point raise had been widely expected. The question now, however, is whether it will prove to be the last.

The answer is almost certainly "no." Most market analysts now expect the Fed to raise interest rates at least once more over the coming months, to 5 percent, because American economic growth has rebounded strongly, and that, without a firmer application of the brakes, inflation will soon start to accelerate.

It is true that inflation remains modest - the closely watched Consumer Price Index (CPI) rose only 0.1 percent in February, compared to 0.7 percent for January, according to the Department of Labor. But if growth continues to outpace the economy's long-term productive potential (which depends on the growth in productivity and of the labor force), labor shortages and capacity constraints will eventually push inflation up.

The unemployment rate has already dropped to 4.7 percent (the U.S. economy created 211,000 jobs in March), well below most estimates of the level consistent with low inflation, and most economists are predicting a healthy growth this year. The question, however, is whether it will slow down and prevent overheating and so relieve the Fed of the need to raise interest rates more aggressively.

Although most economists are still forecasting a soft landing (in which annual growth conveniently slows to 2.5 percent and stays there), a small but growing number now expect the economy to remain robust in early 2006 - implying a much sharper eventual slowdown.

Meanwhile, the latter group of economists has become fascinated by the shape of the yield curve, a graph that plots yields on securities of different maturities. In the past, the shape of this curve (most precisely, the gap in yields between long- and short-term bonds) has proved to be a good leading indicator of economic activity.

Why should this be? It is a well known economic fact that, in normal times, investors demand higher yields on longer-dated bonds to compensate them for the greater risk, but the required premium varies according their expectations of growth and inflation and thus the future path of interest rates.

For example, let us go back to 1992-93 and cite the yield curve for those years. The yield curve sloped steeply upward in 1992-93, reflecting the market's expectation that future growth and hence inflation and short-term interest rates would increase. Investors therefore demanded a bigger premium on securities with a long maturity.

By contrast, when the Fed lifts short-term interest rates in order to dampen growth, this widens the gap between long- and short-term bond yields; and those for long-term bonds will fall as inflationary expectations ease.

If the Fed continues to tighten policy, short-term rates eventually will rise above long-term rates and the yield curve will become "inverted." Because investors expect weaker growth in the future and hence lower interest rates, they will accept lower rates on long-term bonds.

As a forecasting tool, the yield curve has an impressive track record - it has become inverted 12-18 months before every recession during the last 50 years, and only once over that period has there been a false alarm, when an inversion curve was not followed by a recession. That was in 1965-66, when heavy government spending during the Vietnam War helped to avert a full recession, and growth merely slowed.

So, what is the curve signaling now?

The conventional wisdom is that an inversion of the yield curve is unlikely because inflationary pressures are weak and because the Fed started to tighten policy early in the economic cycle - interest rates need not rise much further.

This argument might be more convincing were it not for the fact that in 1988 many economists similarly argued that the yield curve, which was then also flat, would not invert, but in 1989 it did, leading to the recession of 1990.

However, this time around, the Fed is hewing to a tougher approach. "It must weigh future inflationary risks against the danger of pushing the economy into recession," most analysts are saying.

The trouble, however, is that there are long lags before changes in interest rates affect economic activity, and the extent of their impact is unclear.

Nonetheless, Ben Bernanke, the Fed's new chair and the leading advocate of "inflation targeting," opines that "the idea that central banks should set a target for inflation and stick to it cannot, except by sheer luck, bring the rate of growth exactly in line with the economy's productive potential."

"The best he can do to avoid a recession is to prevent serious overheating, but Mr. Bernanke is facing an uncertain international economic climate," some economists are saying.

Luckily so far, however, increasing U.S. interest rates have helped the U.S. dollar to soar against European and Asian currencies. There is a Damoclean sword hanging over the dollar, however - the huge U.S. trade deficit, which is running at an annual rate of nearly US$700,000,000,000, and is the ultimate problem besetting the American economy.

"As it keeps growing, so do fears that there will be a run on the dollar, which would force the Fed to intervene," most analysts are saying.

Meanwhile, to mitigate this crisis, different economists have prescribed different solutions, but most agree that only a devaluation of the dollar or revaluation of other currencies can assist the American economy in the long run.

That is why the U.S. government is pressing the Chinese so hard to raise the value of its currency, something the Chinese (with its flood of cheap goods destined for the American market) have been opposing.

Moreover, in the short run, what is preying on the mind of the Fed is the possibility that the adjustment to the trade gap could entail both a slowdown in consumer spending and increased pressure on prices. And sadly, in the long run, the large budget deficit will put a lot of pressure on the U.S. dollar by reducing the U.S. savings rate.

Ben Bernanke, the world's most powerful central banker, has a rocky road ahead - is he up to the challenge?
©2006 OhmyNews
Other articles by reporter Bhuwan Thapaliya

Add to :  Add to Del.icio.usDel.icio.us |  Add to Digg this Digg  |  Add to reddit reddit |  Add to Y! MyWeb Y! MyWeb

Ronda Hauben
Netizens Question Cause of Cheonan Tragedy
Michael Werbowski
[Opinion] Democracy's Downfall
Michael Solis
Arizona's Immigration Bill and Korea
Yehonathan Tommer
Assassination in Dubai
[ESL/EFL Podcast] Saying No
Seventeenth in a series of English language lessons from Jennifer Lebedev...
  [ESL/EFL] Talking About Change
  [ESL/ EFL Podcast] Personal Finances
  [ESL/EFL] Buying and Selling
How worried are you about the H1N1 influenza virus?
  Very worried
  Somewhat worried
  Not yet
  Not at all
    * Vote to see the result.   
  copyright 1999 - 2018 ohmynews all rights reserved. internews@ohmynews.com Tel:+82-2-733-5505,5595(ext.125) Fax:+82-2-733-5011,5077