Cooling The Us Economy

Stock markets around the world are waiting for today's meeting of the Federal Reserve Board's Open Markets Committee. The Fed is widely expected to raise its funds rate by 50 basis points, an admission that its policy of increasing rates by a quarter point at a time hasn't been working. There are reasons enough for the tightening. One, the US GDP growth rate has exploded in the last three months. Two, the unemployment rate has fallen to a low 3.9 per cent, a signal of rising wage pressures. The International Monetary Fund, in its global economic forecast published a month ago, predicted GDP growth of 4.4 per cent for the US economy, while the inflation and unemployment figures remained low. The OECD now says that that estimate of growth is at the bottom end of the band. In other words, the inference is the US economy is getting overheated, and this will soon result in higher inflation. By that logic, the Fed has no option but to raise interest rates.

 

One target will be the Dow Jones index, which is now far above the 6000 mark at which Greenspan made his famous "irrational exuberance" call. The inflation in asset prices has resulted in a wealth effect, which induces investors to spend more solely because their net worth has risen notionally on the back of a rising market. The long boom has been fuelled by record levels of personal indebtedness.

The contrary point of view is provided by the New Economy theorists, who point to the impressive gains in productivity made by the US economy to assert that there is no fear of inflation. This argument is also used to support the high valuations of New Economy companies. There is no doubt that productivity has improved. But economists have said that this could merely be the result of low unemployment, and longer working hours. And those sceptical of the New Economy point out that the world has passed through similar productivity enhancing inventions earlier, and the same kind of arguments were in vogue favouring electricity and radio stocks in 1929.

On the other hand, the fears about an interest rate rise seem to have finally slowed down the rise of the Dow and the Nasdaq. A 50 basis point increase, together with a warning of further tightening next month, could therefore result in a soft landing for US stocks. US consumer spending has already fallen below income growth, and this should take the pressure off inflation. House-building activity has slowed down. And US interest rates are now high enough for the Fed to be able to reduce them drastically, should the economy threaten to tumble. This acts as a cushion for the downside of a rate hike.

What the Fed does affects the rest of the world, because the US economy remains the world's locomotive. But Europe and Asia have revived, and the slack provided by a slowdown in the US can be taken up by these regions. The risk is that funds may, in uncertain times, flock to a safe US haven, unsettling markets and economies around the world. It is this fine line between panic and exuberance which the Fed will have to draw today.