John Rapley
RECENT DEVELOPMENTS in the world's largest economy have raised possible warning flags of trouble ahead. The United States economy, as I wrote earlier in the year, runs the risk of sliding into something called 'stagflation', an unhappy blend of rising prices and declining employment. Recent data seem to have confirmed this danger. Although economic activity has slowed, and confidence indicators which are used to predict future activity have dropped, inflation has been creeping upwards. It shows few sign of slowing.
The Federal Reserve Board is getting anxious. Admittedly, the rate of inflation - somewhere in the order of two to four per cent - is one we here would love to have the luxury of worrying about.
Nevertheless, while inflation is still low, Fed governors are concerned that inflationary expectations are beginning to take hold. That is to say, with prices rising, firms are starting to factor expectations of future increases into their pricing decisions. So too, apparently, have workers. Employment costs in the U.S. have recently been rising faster than they have in years.
INFLATIONARY EXPECTATIONS
History has taught the governors - some of them, like Alan Greenspan, old men with long memories - that once inflationary expectations take hold, they can be very tenacious. Accordingly, the men and women at the Fed seem determined to nip these expectations in the bud. To do so, they have been raising interest rates.
But herein, they face a problem. In recent years, some financial analysts have been talking of the "Greenspan put", the implicit guarantee by the Federal Reserve Board to protect asset prices from severe declines. The evidence for such a form of 'moral hazard' is mixed. Still, many American investors appear to have taken the examples of the Fed's responses to market slides in 1998 and 2000 to mean that the Fed, to protect the overall economy, will cut interest rates sharply any time there is risk of a market crash.
Some observers have used this confidence to explain the 'conundrum' of which Fed chairman Alan Greenspan has spoken of late: the fact that long-term interest rates fell even as the Fed was raising short-term rates. The reasoning was as follows: the Fed's rate rises would prick the housing bubble and bring down the stock market in the short term, leading the Fed to cut rates down the road.
It may also be that the decline in long-term rates reflected the supreme confidence Americans - supported by investors from around the world -- have in their central bank. Regardless of their causes, though, declining long-term rates encouraged people to keep crowding into the sort of high-risk investments the Fed was trying to discourage. Property-speculation and purchases of stocks that, by historical standards, were considerably over-valued, were prime targets.
In recent weeks, Fed governors have been speaking out, insisting that they will keep hiking rates until markets get the message. In addition, though, the fallout from hurricanes Katrina and Rita may have provided the straw that broke the camel's back. When U.S. President George W. Bush - in an effort to shore up his plummeting approval ratings - announced that Washington would pick up the tab for post-storm reconstruction, many investors concluded that the back would bust. With federal debt surging, but U.S. investors putting little money in the bank, it became more likely that foreigners would begin demanding higher premiums on their loans.
LONG-TERM RATES
In any event, long-term rates began rising, and have been doing so for weeks. It is likely they will stay on this course for the foreseeable future. As they do, mortgage and debt payments will pick up for ordinary Americans. This could curtail spending and restrict the flow of money into assets. It is not inconceivable that at some point, a meltdown could begin in those very markets, with housing and shares being particularly at risk.
Part of the reason commodity prices continue rising is that many investors see them as safe havens, since their supply is comparatively restricted and so they cannot be 'printed', as the Fed has done with money. But rising commodity prices further feed U.S. inflation. This may be a case of the Fed paying the price for past indiscipline. Fallout - though still only a possibility - would, if it came, be painful.
John Rapley is a senior lecturer in the Department of Government, UWI, Mona.
