Economic Growth May Not Remain as Stratified as Assumed

October 8, 2014

The case for continuing dollar appreciation seems very strong based on diverse growth trends, interest rate differentials, and credit policy situations between the United States on the one hand and the euro area and Japan on the other.  New IMF forecasts released this week project 2015 average GDP growth of 3.0% in the United States versus 1.3% in Euroland and 0.8% in Japan.  These estimates are fairly representative of what other groups are forecasting and exceed America’s advantage in 2014.  The ECB has announced a number of stimulatory measures since June that appear insufficient, strongly suggesting that even more actions will be forthcoming soon to avert what the IMF calls a 30% chance of deflation commencing next year.  The Bank of Japan is falling short of achieving its goals, so its current program of bond buying may need to be past March and into 2016 and/or supplemented with other unconventional measures.  Federal Reserve officials, in contrast, have been preparing markets to anticipate an initial federal funds rate hike no later than mid-2015 and possibly as soon as March.  The dot-scatter chart distributed by the FOMC appears to suggest that 4 to 5 hikes of 25 basis points will be made next year and 6-8 more in 2016. 

2015 will not so much as be a changed configuration from the current year as an extension of the gap in performance seen this year and the fact that monetary policies already are unsynchronized.  Likewise, the euro this year has declined against the euro by over 10% from 1.3993 to a recent low of $1.2500, and the dollar’s best value this year was some 45% higher against the yen than its 2012 low.  The case for dollar appreciation next year is an argument for more of the same.  The simplicity of the conclusion begs the analyst to ask what can go wrong?  And the first reason to temper one’s confidence in this forecast is that expected foreign exchange movements so often do go astray.  In fact, the IMF has had to reduce its projected 2014 growth rate from 3.1% made 21 months ago to 2.2% in this week’s revised World Economic Outlook.  That revision was considerably larger than those made to Japanese and Euroland growth, which were very pessimistic from the start.

The U.S. economic upswing, now just past five years, has been soft by historical comparison.  Real GDP expanded 11.7% or 2.2% per year between 2Q09 and 2Q14.  That’s down from 2.8% per year over the first five years of the previous expansionary business cycle, an annual pace of 3.1% in the initial five years of the early 1990s upswing, and 5.0% per annum between end-1982 and end-1987.  Five years after those three earlier recessions, the federal funds target was respectively at 6.0%, 5.25% and 4.75% versus a targeted range now of 0-0.25%.  Analysts that focus just on the higher rate of U.S. growth neglect to realize that inflationary pressure is better correlated with the level of actual demand vis-a-vis the long-run trendline for the level of potential GDP.  The U.S. economy has performed worse than in prior upswings in spite of a much more stimulative monetary policy this time.  Moreover, incremental economic growth has been distributed to just a tiny fraction of the U.S. population.  Most people are not as much better off to cope with tighter Fed policy as the average per capita GDP increase since the Great Recession implies.  In addition, the rising dollar already underway represents a de facto tightening of monetary policy that will impact the economy adversely but with a lag. 

Still to be proved, therefore, is how well the U.S. economy will handle the upward ratcheting of the fed funds target, but one thing that’s reasonable to assume is that Fed officials will not follow the currently implied path unless the data next year and in 2016 support it.  It’s possible that economic growth and short-term interest rate differentials between the United States and other economies may not widen as much as current conventional wisdom has assumed.

Even if the economic data evolve as projected, financial market paths are likely to exhibit greater convergence among nations.  A lesson since the Great Recession is that equity prices in different countries march to a similar beat, direction wise.  So do long-term interest rates.  Diversification looks great in theory but hasn’t provided as much protection as presumed.  If other financial markets do not behave as diversely as underlying economic fundamentals suggest, why should foreign exchange conform nicely to preconceived notions?

Finally, many intangible uncertainties have surfaced, and a number of these put the United States in a poor light.  The November U.S. election could be a bloodbath for the Democrats, creating a political backdrop that will make the Obama presidency weaker than ever, yet leave confidence in other aspects of government very low.  Adverse ramifications would extend way past fiscal policy, tarnishing not only the president.  Confidence will be eroded that America will act proactively enough to contain threats from ISIS, infectious diseases, decaying infrastructure, and climate change.  The external value of the dollar reflects the present value of the leadership role investors envisage the United States playing ten, twenty-five or fifty years from now.  If that quotient needs to be downgraded, the dollar will not be able to sustain the kind of multi-year upward runs it enjoyed in the early 1980s or late 1990s.

Copyright 2014, Larry Greenberg.  All rights reserved.  No secondary distribution without express permission.



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