As this is a note on U.S. monetary policies, it is perhaps fitting to begin with an apparently lost Wall Street art of “Fed-watching.”
Media reports of reportedly sudden “discoveries” of the Federal Reserve’s radical policy changes should be yesterday’s news for analysts who make the effort of looking at the U.S. central bank’s balance sheet, and who know how to read it.
A slowdown in the downward adjustment of the monetary base — known as “M0,” and the only measure of money supply the Fed directly controls — became quite clear in January, through to mid-March.
Between January and the last reserves report on March 13, the Fed raised its asset holdings by $61.7 billion, while still leaving the high-powered money 9.7 percent below its level from a year earlier.
That offered some support to U.S. fixed-income markets because, over that period, the yields on Treasury’s two-year maturities fell 34 basis points, and remained virtually stable on the benchmark ten-year note.
Did that also help to anchor inflation expectations? Perhaps it did, but the jury is still out.
Caution is in order. The Fed is a short-term forecaster working with an uncertain outlook for key variables influencing labor and product markets in an open economic system.
Take inflation as an example. Consumer prices for February showed a relatively benign picture for most items — except for the energy sector, where imported fuel and natural gas prices rose sharply in the first two months of this year.
That is a typical case where a forecast crucially depends on unpredictable political and security considerations affecting the foreign sources of the supply chain. Output decisions of a fractious oil cartel, and its associates, are hard to assess now with social unrest in Venezuela, Iran sanctions and increasingly hostile U.S. relations with China and Russia.
In such an inauspicious environment, a continuation of 4.1 percent and 4.9 percent monthly imported fuel price increases in January and February, respectively, and double digit advances of imported natural gas prices could have serious consequences for the U.S. price stability in the months ahead.
One should also note that those developments are unfolding at a time when inflation is already hitting the upper limits of Fed’s policy targets — the latest price index for personal consumption (excluding food and energy) is at 1.9 percent and the core CPI is at 2.1 percent.
And all that is happening in a fully-employed U.S. economy growing at a rate of 3 percent, a pace of advance that is an entire percentage point above the estimated non-inflationary growth potential of 2 percent. That potential is a physical limit to non-inflationary growth set by the stock and quality of human and (physical) capital.
People who worry about an incipient slowdown of the U.S. economy don’t realize that household consumption, residential and business investments – nearly 90 percent of the country’s GDP – are driven by high employment, a 3.9 percent growth of the households’ real disposable personal income and some of the lowest real interest rates on record.
In fact, the U.S. economy is being literally fired up by an explosive policy mix.
On top of an extraordinarily easy monetary policy, there is a reckless fiscal expansion with the public sector deficit of 7 percent of GDP, and a gross public debt of $22.1 trillion, or 106 percent of GDP.
So, instead of worrying about a destabilizing economic management, Washington is concerned about a slowdown of a much more balanced euro area economy. A trifle and nothing to worry about: All American goods sales to Europe last year — $370.3 billion — are just 1.8 percent of the U.S. GDP.
Trade tensions with China are another concern, presumably because Wall Street fears that a possible loss of American $120.3 billion exports to China recorded last year – 0.6 percent of U.S. GDP — would devastate the U.S. economy. Ridiculous, isn’t it?
War and peace issues with China are serious, but that is an entirely different matter.
There, however, is one problem with trade that is not getting the attention it deserves.
Washington’s messy and protracted trade dispute with the European Union and China can seriously disrupt supply chains and set in train rising prices in an unpredictable manner.
That’s what the Fed should worry about. Prices of foreign goods would increase as a result of tariffs, quotas or other impediments to trade. At the same time, domestic prices of import substitutes would also go up — those are technically called sympathetic price increases as domestic producers move to beef up their profit margins.
The resulting upward price pressures in a fully-employed economy would leave no choice to the Fed: Interest rates would have to go up.
The only respite could come from the possibly rising exchange rate of the dollar. That would make European and Chinese goods cheaper, but it would also infuriate Washington about manipulations of the euro and the yuan.
The Fed is right in its positive assessment of the economy.
The American central bank’s concern about weakening European and Chinese economies can be safely ignored. But worries about trade disputes are well taken because they can raise the U.S. inflation and lead to a sharp reversal of the current wait-and-see policy stance.
Rising prices in energy markets are another serious inflation issue to watch. Those markets are influenced by political events within the oil cartel, Russian oil and gas trading, social unrest in Venezuela, and the extent to which China and India can continue to ignore U.S. attempts to block Iran’s oil and gas sales.
The bottom line is: The U.S. economy is doing well; inflation issues are incorrectly minimized; and the Fed can manipulate its balance sheet, but interest rate hikes are its only response to rising inflation.
Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York, and taught economics at Columbia Business School.
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