- The uncooperative American consumer
- Recession and the inverted yield curve
- Inflationary expectations in the US and Europe
The euro climb against the dollar, intact since the beginning of August, broke down conclusively on Friday with the united currency closing below 1.4450 for the first time since early November. Surprisingly it was the American consumer that shoved the euro lower. All the recent doomsday scenarios for the dollar have run through the spending habits of the US consumer. Battered by falling house prices and frightened by the credit crisis, US consumers were supposed to begin a retreat from their free spending ways. Consumer spending is 70 percent of the US GDP, as it fell, production and jobs would ebb away, inhibiting consumer spending even more, and the whole cycle was due to end in a severe slowdown or outright recession. Notwithstanding that it was these same terrified consumers who powered 3rd quarter GDP to a 4.9% expansion, the currency markets have been waiting confidently for the collapse in consumer spending, the US economy and the dollar.
Thus far the US consumer has not cooperated. Retails sales in November, released on Thursday, were much stronger than anticipated. The euro began to move lower with the sales figures but it was the CPI inflation numbers on Friday that delivered the heaviest push. With core CPI 2.3% higher than last year, consumer spending strong and industrial production buoyant the prospects for another Fed rate cut at the end of January diminished appreciably and euro selling began in earnest.
The financial markets have been traumatized by the credit crisis. The seizing of the medium term credit markets and the inverted yield curve are troubling signs for the US economy. An inverted curve, with long term rates lower than short term rates, is a traditional precursor of recession. This is true despite the fact that all inversions have not been followed by recessions and all recessions have not been preceded by an inverted yield curve. The logic of inversion is simple. Falling economic growth elicits rate reductions from the Fed, the farther end of curve drops as expectation for a reduction cycle takes hold. Since the end of the cycle is not in sight when the rate cuts begin anticipation keeps future rates low until signs of economic recovery are apparent. The current problem, though it is not really a problem, is that the economy has not yet faltered. The Fed has begun to reduce rates to ameliorate the unusual economic circumstances, a prolonged housing decline coupled with a credit crunch that could, if extended, deny credit to business, and to head off the anticipated economic slowdown. Mr. Bernanke is taking out insurance, as he has said, but as in any insurance purchase the insured circumstance has not yet occurred.
In all of these considerations the simple fact remains that the economy has not slowed yet. The housing slump has been an economic reality for more than 18 months, the credit crisis for four, two of which were in the third quarter but the economy grew at a blistering 4.9% in that quarter. Job creation remains moderate and real wages, taking into account health care and other services, are expanding at more than 3.0% annually.
Housing wealth does contribute to the consumersâ€™ overall asset picture but it may not be as important to daily spending habits as many economists and commentators have surmised. Jobs, rising wages, low interest rates and available consumer credit may be far more important and may yet keep the seven year US expansion in moderate forward gear. An American economy at 2.0% or 2.5% GDP growth in the next two quarters is not a scenario for a falling dollar. Traders have begun to entertain the possibility of a far more resilient US economy and a far less crippled US dollar.
The rapid decline of the dollar against the euro since August has been predicated on two linked assumptions: first that the American economy will bend if not break under the accumulated weight of the housing collapse and the credit crisis and second that in order to alleviate the worst of these potential developments the Federal Reserve will push rates lower for the first half of 2008. Both assumptions were called into question by the economic data this week and the dollar had its best two days in over three months. There is a good chance that the direction of the dollar for the remainder of the year has been set and it will see further gains into the New Year holiday.
The American Federal Reserve dropped the Fed Funds target rate for the third time since September to 4.25%. The 0.25% cut made the total reduction 1.0% in less than three months. The discount rate, the cost for banks to borrow directly from the Fed, was cut 0.25% to 4.50%. The rate reductions were the minimum expected by the market. The FOMC statement cited intensification of the housing crisis and some softening in business and consumer spending as reasons for the cut. It also mentions inflation, but the FOMC made its decision about inflation vs. growth back in September so the notice that price risks are still evident is neither here nor there.
Directly addressing the severe shortage of medium term liquidity in the money markets, the Federal Reserve and four other central banks have arranged an auction funding facility. It is hoped that the greater access to funding that this facility will provide will enable many banks which do not have direct access to the Fedâ€™s money market cash injections to secure direct financing from the central banks if they are unable to fund through normal commercial channels. The bankers are clearly still struggling with how to provide liquidity to a market whose private lenders have become extremely risk averse, so much so that normal money market funding between commercial entities has been drastically curtailed.