BT: US economy: entering the fear zone

Business Times - 13 Nov 2007
US economy: entering the fear zone

The credit crunch and the weak dollar could force Americans to finally start to pay back the money they borrowed

By LEON HADAR WASHINGTON CORRESPONDENT

AS the US dollar reached an all-time low against the euro and oil prices rose close to US$100 a barrel and the housing market experienced one of the steepest downturns in two decades, the last thing that Congress and Wall Street needed was to have US Federal Reserve chairman Ben Bernanke tell them that they should expect a 'sluggish' US economic growth in the near future.
At the same time, he hinted that the US central bank had no concrete plans to cut interest rates anytime soon. Yes, the economy was slowing down and that there wasn't much he could do about it. You'll just have to get used to it.

But that was exactly what Mr Bernanke did last Thursday during his much anticipated testimony before a joint economic committee on Capitol Hill.

It is quite possible that both lawmakers and investors were fantasising that Mr Bernanke would suddenly remove a mask and that they would discover that it was Alan Greenspan addressing them, coming up with all the financial mumbo-jumbo that no one really understood but that nevertheless could make them feel so good.

They must have been hoping that the Wizard from the Fed would bless the American and global economy with his magic touch, AKA interest rate cuts, and the good times would roll once again.
But there was no Mr Greenspan and it was Mr Bernanke responding to a question from Democratic Senator Chuck Schumer from New York: 'Our assessment is for slower growth, but positive growth going into next year.'

He added that 'we hope' that by the spring, early next year, that, 'as these credit problems resolve and as, we hope, the housing market begins to find a bottom, that the broader resiliency of the economy, which we are seeing in other areas outside of housing, will take control and will help the economy recover to a more reasonable growth pace'. But then, hopes never provided a strong basis for effective policies.

And 'do you think that the decline in the dollar will lead to inflation and higher long-term interest rates?' asked another lawmaker.

'The decline of the dollar has the potential to raise import prices and contribute to inflation,' Mr Bernanke admitted. 'And, therefore, we are very attentive to that risk.'

And what about the rising petrol prices and their long term impact on the American consumers and economy? 'This is a big burden for the US economy, although we've been pretty resilient so far in dealing with higher oil prices,' according to Mr Bernanke, stressing that while the price of oil 'has its effects on consumer spending, it's obviously also an inflation risk, both because oil prices are part of the consumer's basket and therefore part of inflation'.

And even 'more concerning' would be if those petrol prices were to feed through into other costs and lead to a broader rise in prices, he added.

Hence it was not surprising that last Thursday's testimony in which the Fed chairman seemed to be going out of his way to sound un-Greenspan-like, only added to the mood of gloom and doom that has been dominating Washington and Wall Street in recent days: The debacle in Iraq, fears of war with Iran, instability in Pakistan, rising oil prices, weakening dollar, housing crisis, credit crunch, weak US dollar, high oil prices - and now comes the head of the US central bank who not only expects the economy to slow down, but who also says that inflation is going to be a concern.

So those of us who operated under the impression that you can't have both a recession and inflation at the same time - inflation being a sign that the economy is overheating - learned from Mr Bernanke that the American economy was moving into a stage in which it could be suffering from both of them at the same time.

That means that the Fed would be facing a dilemma since its main policy instrument - interest rates - is supposed to deal either with the threat of inflation (raise rates) or the threat of recession (cut rates) - but not with both at the same time.

All of which raises the expectation of a 'neutral' Fed that is likely neither to raise nor cut interest rates in the near future, news to which Wall Street has reacted negatively.

Indeed, there are growing signs that the mood of gloom and doom is being translated into a sense of fear among lawmakers and investors as well as the public/consumers who are recognising that things are going to get worse in both the foreign policy arena and the economy, and that America's policymakers have no answers to how to get out of Iraq, avert a war with Iran, prevent Islamic radicals from taking over Pakistan's nukes as well as how to ward-off recession and inflation, while doing something about the rising oil prices and the collapsing US dollar.

Even more depressing is the fact that all these and other foreign policy and economic issues seemed to be intertwined: Instability in the Middle East that increases the US budget deficit and puts downward pressure on the US dollar while at the same time leading to a rise in oil prices which accelerates inflationary pressures but which could also create the conditions for a possible recession.

And a weak US dollar could provide incentives for the Chinese - who hold bonds equal to almost half America's debt and who see the value of their investments decline - to look at putting money into euros instead of the dollar as a Chinese official hinted last week.

At the same time, since oil is priced in US dollars, there is pressure on oil producers to increase the price of oil when the value of the US dollar falls and perhaps even to consider the idea of oil being priced in euros.

One could put a positive spin on all the bad economic news by suggesting that after several years during which Americans have been living beyond their means, with business and consumers accumulating debt and producing a huge deficit as though there was no tomorrow - the chickens are finally coming home to roost.

The credit crunch and the weak dollar could force Americans to finally start to pay back the money they borrowed, increase US exports abroad and narrow the deficit while helping eventually to stabilise the US dollar.

The problem is that there are too many economic and geo-strategic unknowns in this picture - the depth of the housing crisis and the credit crunch; the chances for a war with Iran and continuing instability in the Middle East; the level of growth in energy consumption by the Chinese and the Indians; US economic tension with the Chinese - that could make it more likely that a painful economic correction could be transformed into a dangerous economic crisis. Hence the fear in Washington and Wall Street.