The Economy Can't Count On Help From Washington Or The Dollarby
If the Federal Reserve has truly shifted monetary policy into neutral, then the U.S. economy finds itself in an unfamiliar position. For the first time since 1989, the net thrust from Washington's two main policy levers is now contractionary: The central bank is neither stimulative nor restrictive, and the shrinking federal deficit means that fiscal policy is a drag.
This shift is a big reason why the economy is far from overheating. In fact, it suggests that the peak growth rate in this expansion is near, as the economy must move forward on its own momentum. This doesn't mean that recession is just around the corner--it isn't. But it does suggest that growth in 1995 could be a notch below 1994's.
The deficit declines since 1992 have been impressive. With the key April data now in hand, the budget gap for fiscal 1994--ending in September--is on track to dip perhaps as low as $205 billion, led by an acceleration in receipts and slow growth in outlays (chart). The Treasury posted a $17.5 billion surplus in April, twice last April's level, mainly reflecting the tax hike on high-income individuals. Outlays were no higher than they were a year ago.
If that projection is on the mark, the deficit would be down from $254.7 billion in 1993, and from $290.7 billion in 1992. It would also be lower than the Clinton Administration's forecast of $220 billion to $230 billion. The White House sees a further drop in 1995, to $165 billion.
The trouble is, the loss of fiscal stimulus in 1993 was offset by the economic boost from lower long-term interest rates, as a result of the bond market's euphoria over the Administration's resolve to cut the deficit. Now, partly because of the Fed's recent hikes in short-term interest rates, long-term rates are back up sharply, and the shrinking deficit's drain on growth has not subsided.
Moreover, while the central bank seems satisfied to sit back for a while and see what one of its steepest four-month rate hikes in the postwar period has wrought, it appears to have left the door open for another hike or two later on this year, if needed.
Will it slip another one through the crack? Two arguments say no. One, the real federal-funds rate, adjusted for inflation, now is near its long-run average, a proxy for neutral policy. And two, the growth of bank reserves, the fuel for money and credit, has fallen to zero during the past four months, a sign that Fed tightening is achieving its desired results.
Still, one argument says yes: The dollar failed to rally following the Fed's May 17 hikes, and another round of dollar weakness by itself could raise fears of import-led inflation. The sagging greenback appears to be rooted in the deteriorating U.S. trade deficit, which means the dollar could remain vulnerable for some time.
That would further cripple the bond and stock markets--and thus force the Fed's hand. Indeed, in an unusually bold statement for a Fed governor, Lawrence B. Lindsey said on May 25, "One cannot imagine New York retaining its role as the world financial capital if the dollar did not retain its leading role as a world currency."
But even without further tightening, the economy will feel the impact of higher rates. During the past year, interest-sensitive sectors of the economy--including consumer durables, housing, and business equipment--have accounted for 80% of the economy's growth. The pace of those sectors will slow noticeably in the second half.
That's especially true for housing and consumer durables. Although they make up only 14% of gross domestic product, they have contributed 40% of the economy's growth from a year ago. Already, fixed mortgage rates have hit 8.65%, home-purchase mortgage applications have fallen to the lowest level of the year, and refinancing requests are off sharply.
Durable-goods makers are seeing some slowdown in demand. New orders were up just 0.1% in April--and all the strength was in defense ordering. Bookings for transportation equipment fell for the third consecutive month, as a result of car and truck demand beginning to taper off.
So with domestic demand facing constraints, exports loom increasingly important to the outlook. The March data were encouraging. Shipments of goods bound for overseas surged 12.7% from February, to a record $42.2 billion (chart). Capital goods were especially strong.
That gain outstripped a large 6.5% increase in imports, allowing the deficit for goods to shrink from $13.5 billion in February to $12 billion. The trade gap for both goods and services narrowed from $9.5 billion to $7.2 billion in March.
The outlook for exports is good, given improving prospects for the European economies. But recoveries in Germany, France, and elsewhere on the Continent will be slow to develop and not particularly strong upon arrival.
The real problem, though, is that the U.S. continues to import at a faster pace than it exports, and that's likely to remain true well intl 1995. In addition, U.S. stocks, bonds, and other assets are not particularly alluring to foreigners now, meaning the country is not attracting the capital needed to finance its overconsumption. As a result, America's current-account balance--including goods, services, and financial flows--is heading deeper into deficit.
That's a classic recipe for a weak currency--and the foreign-exchange markets have taken notice. The greenback has gone nowhere vs. the German mark over the past four years, and it is down 6.3% against the Japanese yen just during the past year.
Ironically, better economic growth and higher real rates should be a sure-fire tonic for the dollar, especially against the mark. After all, the U.S. is in its third year of expansion, while Germany is just showing signs of a recovery, and Japan may still be in recession. Plus, after the latest round of European interest-rate cuts and the Fed's rate hike, real interest rates, using 10-year bonds, are much higher in the U.S. (chart).
Certainly, a dollar rally is possible, if not likely, especially with the central banks synchronizing intervention in the currency markets and the recent apparent coordination of monetary policy between the Fed and the German Bundesbank. In addition, trade talks between the U.S. and Japan are set to start up again, and the Clinton Administration has made it clear that the dollar has sunk far enough against the Japanese currency.
But any dollar rally could be short-lived. For one thing, the hefty U.S. current-account deficit with Japan--a big part of Japan's huge surplus with the world--continues to widen. In April, the U.S. merchandise deficit with Japan rose to $5.8 billion, from $4.6 billion in March. All of the increase came from higher imports.
Historically, the bilateral trade balance between the U.S. and Japan has been far more important in determining currency patterns than growth and rate differentials. So, the deterioration in trade, along with past jawboning by Clinton Administration officials for a stronger yen, suggests that there is little support for a cheaper yen.
In addition, the differing outlooks for inflation hurt the dollar, especially in Europe (chart). Most forecasters expect that U.S. and German inflation rates will converge in 1994. But in 1995, Germany's inflation should continue to decline, as will Japan's, while a mature expansion in the U.S. will start to generate gradual upward pressure on U.S. prices, preventing further improvement.
A weaker dollar would make American goods more attractive in foreign markets, but the costs would be high, including imported inflation, sagging financial markets, and perhaps even tighter Fed policy. At a time when its economy is more dependent than ever on domestic and foreign demand, the U.S. can do without the added burden of a swooning dollar.