March 29, 2005
by Irwin Stelzer
Inflation is back, or it isn't. The dollar is back, or it isn't. There is a dangerous housing bubble, or there isn't. The trade deficit is worrying, or it isn't. The Fed is about to become more aggressive in raising interest rates, or it isn't. The economy is headed for steady, high growth, or it isn't. That's the clear consensus of America's economists and market watchers.
Start with inflation. The Federal Reserve Board's monetary policy committee continued its measured, quarter-point increases in short-term rates. But it noted that the economy has moved from "moderate" to "solid" growth, and that inflation is no longer "relatively low." And the day after the Fed meeting the government announced that the core inflation rate (excluding food and energy) has hit 2.4%, its highest level since May 2002.
Chairman Alan Greenspan warned last November that "rising interest rates have been advertised for so long … that anyone who has not appropriately hedged this position by now obviously is desirous of losing money." It must be wonderful to be in a position to make your own forecast come true, which he is in the process of doing.
Greenspan knows that it will take about eighteen months for rising rates to cool inflation, and that real interest rates (adjusted for inflation) are still close to zero. So he will have to be quite aggressive. When the Fed's monetary gurus say that "pressures on inflation have picked up in recent months," they are warning that they have turned off the automatic pilot that has resulted in seven quarter-point increases. From now on, the Fed will be data-driven.
The Board's economists will be feeding data on tightening labor markets, increased capacity utilization, rising materials costs, and increased pricing power into their models and, more important, into Greenspan's data-crunching brain as he factors in globalization of capital and labor markets in his hunt for clues to the whereabouts of that Holy Grail, the "neutral," or equilibrium interest rate that neither stimulates nor slows the economy.
The Fed's recognition of the possible need for higher interest rates was bad news for bond investors, but good news for dollar bulls. Former White House chief economist Larry Lindsey points out that short rates are now 0.75% higher in the U.S. than in Germany, and long rates are almost a full point higher. Moreover, U.S. rates are headed up, while, as Lindsey puts it, "There is no reason to expect tightening in either Europe or Japan in the foreseeable future." That combination makes dollar-denominated assets attractive, and is a prescription for a stronger dollar, which will keep the price of imports from rising, and dampen inflationary pressures.
But not enough to prevent further increases in interest rates. Which is causing some nervousness about the outlook for the housing market. Higher rates could bring the boom in the housing industry to a screeching halt, and home prices, up 11% in the past year, would register a precipitous decline.
But knowledgeable home-builders say that so long as mortgage rates stay below 7.0-7.5% (30-year rates are now around 6%) the boom will continue. They point out that new home sales in February increased by a stunning 9.4%; inventories of unsold houses are falling; the rate of new household formation continues to rise, underpinning demand; and even with interest rates edging up and house prices rising, houses remain affordable by any historic measure.
U.S. residences are now worth almost $17 trillion, and mortgages against them come to only a bit more than $7 trillion, leaving what Greenspan calls a "fairly large buffer against price declines."
So homeowners can relax. But can holders of dollars? The dollar did rally last week, and Lindsey sees "a bullish scenario for the dollar for the near term…. With higher yields and lower risk, the Dollar now is likely to be the world's Coupon Currency -- at least among the major currencies of the world."
David Levey, formerly managing director of Moody's Sovereign Ratings Service, and Syracuse University economist Stuart Brown agree. In the recent issue of Foreign Affairs they write, "The U.S. dollar will remain dominant in global trade, payments, and capital flows, based as it is in a country with safe, well-regulated financial markets….Global asset managers will continue to want to hold portfolios rich in U.S. corporate stocks and bonds… [and] for foreign central banks … U.S. Treasury bonds [and] government-supported agency bonds …will remain, for the foreseeable future, the chief sources of liquid reserve assets."
So the data suggest. China upped its dollar purchases by 40% last year, to $195 billion, in order to maintain the renminbi's peg to the dollar -- and to keep its export-led growth at close to double-digit rates. Depression-threatened Japan also continues to stock up on dollars to prevent further rises in the value of the yen.
But everything points to continued high trade deficits, which should in the long-term weaken the U.S. currency. Slow growth in Europe curtails purchases of made-in-America goods, America's rising appetite for imports keeps dollars flooding out into world markets, and currency manipulation in Asia continues to subsidize that area's exports. Even Secretary of State Condoleezza Rice's use of her Beijing press conference to express concern about our $162 billion deficit with China will not persuade the Chinese authorities to allow their currency to rise.
So here are some guesses: the economy will continue to grow, even as interest rates rise in response to moderate increases in inflation. The dollar will show some short-term strength, but resume its decline in response to on-going trade deficits. Housing will remain a source of strength, although activity and the rate of price increases will ease. A guess, of course, is not a forecast. And note: bankruptcy advisers are scrambling for staff.
A version of this article appeared in The Sunday Times (London).
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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