May 2003
Boom after Baghdad?

Based on the recently released numbers, there is not going to be an immediate economic boom, but an increase in the rate of growth should occur at the end of this year and into 2004. The value of the dollar has fallen to its proper, growth-promoting level. The Federal Reserve has pursued an aggressive policy to the point that real interest rates are negative. Through stimulative monetary policy and improved fiscal policy, the United States is rapidly coming out of deflation.

There are three key variables for the economic outlook. The first is oil prices, which have fallen but are still too high to sustain a recovery. The second is the tax cut the Senate passed yesterday. The elimination of the double-taxation of corporate dividends will have a positive effect on the stock market. And third, measurements of business investment need to be watched closely. With negative real interest rates, at some point companies will have to take a risk and make long-term investments.

This business cycle differs from previous cycles in four ways. First, the synchronization of global slowing among the major industrialized countries makes it difficult for countries to spur economic growth by increasing exports. This is being compounded by the fact that Germany is pursuing restrictive fiscal policy at the same time its GDP is falling; what Germany should be doing is allowing its budget deficit to increase in order to stimulate demand. Next, there is an equity and housing market bubble. Capacity utilization rates are too low and price/earnings ratios are too high. Then there is the tremendous adjustment in exchange rates which has been taking place. Until now this has taken place in an orderly fashion, but the potential for disorderly change could hurt equities. Finally, there still remains significant geopolitical risk in key countries including South Korea and Saudi Arabia.

Coordinated monetary policy action is needed to help combat these negatives. The European Central Bank needs to reduce interest rates. The long-run outlook for the United States is good. The Federal Reserve is not running out of bullets and still has significant means by which to stimulate the economy. If it decides that further stimulus is needed, it is best to take the necessary measures as soon as possible.

The price level in Japan fell by 3.5 percent last year, making cash holdings of Japanese yen an excellent tax-free investment and causing the yen to appreciate despite the Japanese central bank’s major intervention to prevent appreciation. The continuing fall of the price level in Japan is one example of the troubling phenomenon of global deflation. The U.S. Treasury is pursuing a policy of benign neglect of the dollar and refusing to intervene in currency markets which is putting further upwards pressure on the yen. The short-term outlook is gloomy, but the light at the end of the tunnel for the U.S. economy is that the depreciation of the dollar allows deflation to be exported to other countries. It would be more accurate to say that there is a bust after Baghdad, but it is possible there will be a boom at the beginning of next year.

The economic outlook is mixed. Oil prices are still high but will fall as Iraqi oil production comes online. Consumer sentiment rebounded after a dip before the start of the war and is moving upwards. Major stock indices are also up which reflects a positive forecast of future economic conditions as well as lowering the cost of raising capital through equity offerings. Mutual fund managers are reducing their holdings of cash, meaning that they expect a stronger recovery. On the negative side, the recession was highlighted by weakness in business investment. This weakness continues and needs to turn around to enable a strong recovery. Also, the spread between yields on corporate and treasury bonds has been decreasing. Historically this has occurred in periods seeing only tepid business investment.

The mixed economic picture has policy implications. If the U.S. Federal Reserve decides action needs to be taken, it is better to act sooner rather than later because of the lag period between the time when policy is enacted and results are seen. The tax cuts made thus far have been the wrong kind of tax cuts. The economy needs cuts that encourage investment and thus lead to economic growth.