Stop talking the American Economy into Recession

Last month this columnist had opined that the developed world was more likely headed for a milder slowing, rather than full-fledged recession. The New Year has woken up – not entirely unexpectedly to shriller trumpets – as the media, especially television, sees recession around every corner. Each data release is touted as new evidence of the coming recession – little matter that they as often point in the other direction. The losses being totted up by beleaguered US banks of course provide the principal provocation for this obsession with the Armageddon of the Recession. And half of January is yet left.

On 30 January 2008, Mr. Bernanke, the Chairman of the US Federal Reserve and his colleagues will have to take a call on what direction US monetary policy should take over the near-term. It has been a widespread consensus for many months now that the US fed rate would be cut by 25 basis points (bps) on 30 January 2008 and that would be the end of the current round of easing. What the moaners and chanters are hoping to achieve is to stir up such a sense of aggravated concern that the Fed is encouraged (stampeded is the alternate, albeit impolite, word) to make a 50 bps cut, marking the beginning of a second round of monetary easing that might take the Fed rate from the current 4.25% down to 2.50%. The statement by Mr. Bernanke on 10 January 2008 that the Fed would “stand ready to take substantive additional action as needed to support growth and to provide additional insurance against downside risks" was undoubtedly seen by many as a step forward in the not so long march to shaving up to 175 bps off the current Fed rate.

You may ask – what is my grouse with all this? If recession has the US economy already in its maws – as the TV will tell you if you turn it on – why should not the US Fed slash rates and why should not business ask for it? There are several good reasons why not. First, there are few indications that the US economy has yet spun into a downward spiral, as opposed to the likely case of a slowdown. Second, inflation in a sense measures the temperature, or the pace of real activity in the body economic; the analogy is far from perfect, but you don’t normally get a deadbeat economy with a powerful inflation rate. In November 2007 the US economy saw its consumer price index (CPI) rise by 4.3% and the data released on 16 January 2008 showed that in December 2007 inflation had been 4.1%, as against the desired inflation rate for monetary management in the US which is about 2.0 to 2.5%.

Before someone remembers the term “core” inflation rate (which is lower at around 2.7%) note one thing: The idea of “core” inflation is about separating out the permanent component of inflation from the cyclical component, the idea being that some things like fuel and food show cyclical behaviour in their price – going up sharply in one period, only to fall back in the next. Which is why, to get at “core” inflation, energy and primary food are eliminated. But does anyone really think that crude oil prices are at a “cyclical” high of $90–100 per barrel and will soon fall back to $30–40/bbl. If someone believes that, he can stay with the “core” rate – in a nut house. What has happened to energy is a huge structural shift that has permanently put prices at a multiple of what they were five years ago – and there is little reason to believe that this will change. Similarly with primary food prices – from wheat to corn to edible oil to asparagus to meat – the old prices are not coming back. So in the US, in the present circumstances, the headline is for all practical purposes the truer guide of where prices are headed, than is “core”.

In Europe inflation marches on at 3.1% in December 2007 – much above its target of 2.0% – and in the third quarter of 2007, economic growth was quite robust (as indeed was also the case for the USA). EU unemployment also remains low. In large measure because of this, on 10 January 2008, the European Central Bank as well as the Bank of England had both left their interest rate unchanged at 4.0% and 5.5% respectively.

If inflation, even as late as December 2008 in the US was as high as 4.1% (the other CPI index was higher still at 4.3%), could this be reconciled with declining economic fortunes? Yes, in a way if one remembers the “stagflation” of the 1980s. The spoiler is that the “stagflation” of the 1980s was largely on account of the unwinding of large structural changes (that saw the relocation of manufacturing to East Asia for one thing) and included reform of the then prevalent high tax rates, enormous budget deficits and an accumulation of excessive regulation in a host of businesses.

To cut a long story short, if underlying demand in the US economy is strong enough to keep headline inflation at over 4.0% and with little prospect of oil prices softening significantly, for the US Fed to meet the interest rate expectations of Wall Street, it will have to alter the emphasis that it places on containing inflation. There have been parallels drawn with the unscheduled rate cut in the beginning of January 2001, just before the US economy did tumble into a recession. Like so many things about today’s commentary the comparison fails to persuade. First, at the end of 2000 it was pretty clear that the US economy was decelerating from previous highs and there was plenty of softness as early as in the third quarter of 2000 (which on revision turned out to be one of negative growth). Whereas in the current period, growth has moderated since the middle of 2006 itself and if anything there have been signs of improvement in recent quarters.

As regards the losses that major US banks are reporting – let us step some months back to September 2007. The figure for total loss on account of the sub-prime problem was being estimated at around $300 billion, with about $70–80 billion likely to hit the US banking system proper. These estimates have not changed much over the past five months. Except that when banks actually report losses they make big news, especially if they have to travel all the way to Asia in search of capital to replenish balance sheets.

There is a fragile quality in the current situation, where there is a real possibility, that the US economy can be virtually talked into a recession. In a weak economic situation the first casualty is confidence: Of the consumer, of small business and of investors – small and large. All this talk of recession can and will spook confidence – as the sell down in global equity markets this week is evidence to. The feedback loop works powerfully – both positively and negatively. It will undoubtedly help the US financial sector to repair itself if interest rates take a nosedive. However, if this were to happen by actuating a recession that would be otherwise only have been a modest slowdown – the phrase ‘collateral damage’ would have acquired an entirely new meaning.

(The author is Economic Advisor, ICRA)

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To be published in Mail Today, Friday, 18 Jan. 2008