The recent flow of data is interesting to say the least. While headline numbers are generally solid, the underlying story looks shaky. Shaky enough that disinflationary trends remain firmly entrenched in the US, whereas inflationary risks appear to be growing in emerging markets. The former suggests the Fed is set to remain on hold, while the latter will push foreign central banks to tighten. In a perfect world, that combination would put downward pressure on the Dollar and support a shift to a more balanced pattern of growth for both the world in general and the US in particular. Yet we persistently fall short of a perfect world. Will this time be any different? The Greek crisis is saying it won’t.
Manufacturing remains a clear bright spot in the economic environment, a point reiterated by the most recent ISM survey. The headline 60.4 was the strongest since 2004, and the underlying details were solid. Employment continues to expand, providing at least a modicum of relief for the beleaguered labor market. The inventory drain became apparent, with more firms than not reporting stockpiles as too low. This suggests further room for manufacturing expansion. The proportion of firms reporting rising prices edged up again, not unexpected considering the complete lack of pricing power and drop in commodity prices at the low point of the recession. Note too that the strength in the ISM numbers is consistent with the solid manufacturing report, with a strong gain in new orders for nonair, nondefense capital goods.
Although the positive tenor to manufacturing is welcome, the first quarter read on GDP reveals a more uneven pattern of recovery, and more worrisome, a recovery that looks a little too dependent on US households. Consumer spending gained 3.6%, contributing 2.55 percentage points to the headline 3.2% gain. The sustainability of such spending, however, remains in doubt. Note that spending growth was heavily supported by falling savings rates, while income growth less transfer payment remains stagnant. This suggests that consumers are once again leveraging up the balance sheets while the deleveraging outside of housing was likely not as deep as initially believed, once bank loan write-offs are accounted for. In short, it looks like we have come full circle. The US economy is again excessively dependent on consumer spending, and that spending is fueled by anything but organic income growth.
The next largest contributor was inventories, which add 1.57 percentage points – clearly part and parcel of the manufacturing revival. Also supportive of that sector was the 13.4% gain in equipment and software category, down from the previous quarter. But a closer look reveals that category, a small part of overall spending, contributed only 0.83 percentage points to growth, and the bulk of that was information technology; industrial and transportation were basically flat. Residential and nonresidential structures were both a drag on growth, illustrating the ongoing weakness of both sectors – weakness that prevents a true V-shaped recovery. Growth, yes, and even sustainable growth. But growth that leaves the economy limping along, heavily dependent on policies to stimulate consumer spending.
With overall investment still falling short of fully supportive of recovery, attention turns to the export story. And, yes, export growth is supportive. The problem is the import drag swamped the export push, leaving the external sector a net negative for growth, sapping 0.61 percentage points from the headline number. This drag throws a wrench into hope that external growth will support the recovery or a rebalancing of global activity. We need to acknowledge the possibility (likelihood) that outsourcing during the past twenty years has left the US structurally dependent on trade deficits. Fueling consumer spending simply translates into a substantially offsetting import increase, thereby preventing the external sector from contributing to growth on net.
Presumably, what we need is policy supportive of a real rebalancing, in which the US consumer is comparatively subdued, keeping a lid on import growth, while the rest of the world is firing on most cylinders. And here is where exchange rate adjustment is important. Faster growth abroad should translate into higher foreign interest rates, which should in turn be Dollar negative. Part of that story is in play. From the Wall Street Journal:
Prices across Asia are rising faster than expected, highlighting the region’s strong recovery compared with the West and raising the likelihood for tighter monetary policy.
South Korea and Indonesia reported higher-than-expected inflation Monday, coming a day after China raised banking reserve requirements in a bid to cool its economy. In a sign that inflation is becoming entrenched, core prices, which exclude volatile food and energy, are ticking up.
Meanwhile, the Fed last week reiterated its commitment to ultra-low rates, which should come as no surprise given the uneven and inventory cycle dependent nature of US growth so far – note that real final sales posted another anemic reading of 1.6% in the first quarter. There is simply not enough growth to rapidly alleviate stress in the labor market, thereby keeping disinflation in play. The March read on core-PCE inflation confirmed the downward trend:
A declining Dollar is the signal to shift production to US shores and alleviate inflationary pressures abroad (while stimulating such pressure domestically), thereby limiting the need for foreign monetary policymakers to hit the brakes so fast that they stifle growth. There is no such thing as immaculate adjustment; a Dollar decline is critical to this process.
It should be a nice, textbook story. Alas, the US external adjustment is anything but textbook. The challenges I see to this adjustment:
1. Export supporting foreign policymakers. Foreign policymakers could attempt to simply shift demand away from internal sources and to the US by raising rates while accelerating reserve accumulation (and sterilizing the subsequent domestic money growth). Indeed, emerging Asian nations would be hesitant to hobble their exporting industries, more so if China does not first revalue the renminbi.
2. The Greek crisis. The Greek drama is obviously far from over; it is not clear that the threat of contagion is even significantly reduced, let alone eliminated. Nor would it be until all the PIIGS committed to a growth sapping fiscal stance, which the Greek public are finding hard to accept. That stance, while perhaps necessary, weighs against global growth and tends to strengthen the Dollar, slowing the rebalancing process. Moreover, I find it difficult if not impossible to believe that the impacted nations can adjust without a significant devaluation. Which suggests the Euro has further to fall. But it is reasonable to believe that, given the German weight in the Eurozone, any decline in the Euro would fall short of what is necessary for the PIIGS to fully adjust. Are we really down to just two choice then? Either Northern Europe commits to perpetual fiscal transfers to Southern Europe (not going to happen), or the Eurozone shrinks? Both suggest a weaker Euro, but the latter points to an outright collapse.
3. The size of the Dollar adjustment. Given the substantial fixed costs of offshoring, it is possible that very large adjustments in the Dollar are necessary to give a lift to importing competing industries in particular. Policymakers may not have the stomach for such an adjustment, resulting in a slow pace of Dollar decline that the support provided net growth is almost negligible.
4.The dependence of everyone on the US consumer. Any rebalancing requires the importance of the US consumer to decline from the current 71% of US GDP. Yet US officials welcome the consumer recovery, and would be hesitant to accept renewed consumer weakness without a clear offset (which they could provide via increase public investment, if they wanted to). And foreign officials, faced with a political class of exporters dependent on US consumers, would be hesitant to risk angering that constituency with a substantial adjustment (see point 1 above).
These are challenges, and are not meant to imply that adjustment cannot occur. Only that so far that recovery has seen precious little such adjustment, with net exports subtracting from growth two of the last three quarters. The combination of tepid US consumer growth, rapid foreign growth, and a steady although not disruptive decline in the Dollar – the combination of factors that present in 2006 and early 2007 – appears difficult to achieve and sustain. I fear it requires a much more substantial global commitment to rebalancing than we have seen to date. And that commitment will be sorely lacking given the Greek crisis. Where the American-led financial crisis forced global policymaker to pull together, the European crisis may push them back apart.