by Paul Petillo
American Reporter Correspondent
February 22, 2005
THE FOUR HORSEMAN OF THE ECONOMY
PORTLAND -- Their fearsome riders and invincible steeds gallop across the darkened landscape, their hooves sparking flames everywhere they go. Here come the Four Horsemen of the Economy: higher interest rates, inflation, a weak dollar and slower growth.
Apocalyptic? Possibly. But certainly the arrival of these swift riders, all at the same time, places considerable weight on those that make decisions concerning the future of the American economy.
Unfortunately, the immediacy of these issues has been open to debate from the highest office in the land to the boardrooms of the nation's top bankers and businessmen. This is no place an intricate and difficult problem without any genuine answer.
And that is what we have: a conundrum.
President Bush will definitely attempt to spend all of the so-called political capital he claims to have won during the past election trying to avoid a face-to-face confrontation with these problems. And with good reason. There have been few success stories from his first term that will lead anyone to believe that he has the ability to face down the inevitable increase in interest rates, a higher overall inflation rate, the stumbling and soon to be tumbling dollar, and the resultant lack of growth.
Interest rates - and not necessarily the ones dictated by the Federal Reserve - have become problematic for the soon-to-be-retired Fed chairman Alan Greenspan. The semiannual Humphrey-Hawkins report delivered to the Senate and the House this past week involved lively questioning and notable sound bites, the very thing this leading economist has been known for providing.
Taken out of context, a comment about the basic logic of tax cuts was embraced in the President's first term while a call to cease spending was not. Greenspan's testimony was heralded a win for the President's yet-to-be-written Social Security plan. Agreeing with private Social Security brokerage accounts was all the Fed chairman need do.
Greenspan has always championed savings except when he was able to actually create an environment where savings was possible. Other Fed chairmen have not been so politically accommodating. When he offered his puzzlement over the bond market's reaction to his short term interest rate increases, he was ignoring a key if not salient point: Bond traders no longer can what he says. They no longer look at his ability to make decisions in a timely fashion. They would benefit greatly from a shift in Fed policy from flexibility to inflationary guidelines. They would like to see the Fed concentrate on prices.
Bond traders now look for risk and are comfortable with meager returns being offered. At the same time, they are calling for the return of the 30 year long bond, a Treasury note that has not been issued since 2001 when it was believed to be too costly especially in light of surpluses as far as the eye could see.
For those of you who may not be able to wrap yourself around the world of fixed income trading, interest rates signify many things to investors. With low rates as they are right now, U.S. assets remain attractive, spending continues, and inflation becomes a non-factor. With higher rates, savings increase, the economy slows, and inflation becomes volatile. Low yields mean the party continues even with the short-term rates increasing at a "measured" pace. Higher yields in the intermediate and long term bond signal an economic retraction of sorts.
Inflation will ride this market down, stripping the equity cheerleaders of their renewed calls for undervalued, under priced, and under appreciated stocks as evidence that the markets are healthy and sustainable. The announcement of the January Producer Price Index number last week however stopped many in their tracks. But only long enough to call the number seasonal and without any real merit. The 0.8% increase in wholesale prices, long anticipated, is finally on the table.
Few investors factor this problem into their investment decisions though. And that could loom larger as the economy begins to stagnant. While many will tell you that growth in the U.S. is still strong, the pricing pressures that Americans are facing - or will face in the next eighteen months will begin to eat at profits forcing companies to continue to pass the cost of doing business on to the hapless consumer.
Adding the volatility of inflation can create unwanted havoc. Market mavens will need to adjust their forecasts while factoring in the possible effect of inflation. Inflation has a derogatory effect on dividend paying stocks as well as utilities and REITs. Fleeing those stalwarts could increase volatility at time when the call for privatization is being sold as the risk-free way to ensure returns for the not-yet-born. What would a sudden market move south do to the President's proposal? It won't help the effort, already facing headwinds they had not anticipated.
The President has allowed the dollar to continue its precipitous fall in the hopes that it will have a positive effect on the trade deficit. That thinking so far has not been proved to be the case. By allowing manufacturing jobs to continue to disappear, a decline that has gone unchecked month over month, and now, year over year, savings in this country has been nonexistent.
And despite what the President says, he hopes it stays that way. Should the 40 million of so baby boomers reaching 50 in the next ten years suddenly decide to stop spending and begin to save for their own less predictable retirement, the thin fabric that has kept the dollar from dropping through the floor will not be able to stop the fall. In a global economy, Americans need to spend.
The flow of funds rate, a newly important piece of information coming out of the Treasury has revealed a significant drop off in foreign interest. While many bond traders have brushed off the importance of the recent 75% dip in buying, the amount of money that foreign investors have lost because of the falling dollar is beginning to mount. Japan, a holder of $715 billion in Treasury notes has lost 5.6% over the last month with the European Union losing $625 million.
While these investors are still looking to American markets for yield, they have shifted their focus to corporate bonds. This, unfortunately, does little to continue to finance the debt that the President continues to spend.
The last horseman, and clearly the laggard, is slower growth. Our attempts at controlling the trade deficit have failed. The further permanency of the tax cuts, something the President is insisting on will be the death knell for the lackluster growth we will experience in 2005. Fiscal responsibility is not a hollow promise that suggests, as the President's budget does, that spending can continue unabated while cuts are being made.
The White House sees a different economic outcome. The Economic Report of the President was released on Thursday with somewhat rosier than realistic expectations. The report does cite a slight downturn in GDP from 3.7% in 2004 to 3.5% in 2005. It also offers a continued decline in the unemployment rate and a tame assessment of inflation at 2%. N. Gregory Mankiw, the author of the report and soon-to-be-returning to his post as professor at Harvard pays little attention to the deficit in those numbers and with good reason.
The belief that deficit spending does not play a role in the overall growth of the economy has been well documented by the White House's chief economist. He refers to them as "prudent price to pay for stimulating economic growth."
The Four Horseman of the impending economic apocalypse will be unwelcome and possibly long-term guests. They signal an unfortunate alignment of events, which can be directly credited to more than one failed policy. What it is not is a conundrum.
Paul Petillo's latest book is Building Wealth in a Paycheck-to-Paycheck World (McGraw-Hill). He is the managing editor of BlueCollarDollar.com, a "common sense" approach to money at http://bluecollardollar.com