US economic forecasts: What should keep chairman Bernanke up at night?

S&P chief economist examines the issues facing the new Fed chairman.

As the apparent incoming head of the Federal Reserve Board, Dr. Ben Bernanke has a tough act to follow. Chairman Greenspan has been perhaps the most successful Fed chairman in history, with inflation remaining calm and with only two mild recessions in 18 years. On the positive side, the incoming chairman inherits an economy that is stable, with low inflation and solid growth. But the problems and imbalances he must deal with are big.

First on the central bank's agenda is always inflation, and the sharp rise in energy prices and construction cost increases caused by the rebuilding of New Orleans has brought that to the fore again. In his academic work and at the Fed, Dr. Bernanke was known as an advocate of inflation targeting. We expect him to move gradually toward that policy as Chairman.

Second has to be the dependence of the U.S. financial market on foreign capital to finance our deficits. The lack of household saving (now negative for a record four months) and rising federal deficit in the wake of Katrina makes us dependent on this massive inflow of private and official money. What happens if foreigners stop shipping us all their spare cash?

The third item on the agenda is the heavy borrowing of the household sector and the related housing boom, which has enabled that borrowing. Household debt is at a record 124% of household after-tax income. The new bankruptcy law and Katrina have created a flurry of bankruptcies, as debtors filed before the new law became effective October 16. Charge-offs will peak in the fourth quarter as a result.

Falco Columbarius

At the current inflation rate, a move to formal inflation targeting is largely a semantic step. A lot of ink has been wasted in trying to decide whether Dr. Bernanke is a hawk or a dove on inflation. The chairman-designate is a pigeon-hawk (Falco columbarius). If inflation drops, he will look more dove-like. At higher rates, he will seem very hawkish.

Fed spokesmen, including Dr. Bernanke when he was on the Board, have focused on a range of inflation of 1.5% to 2% as ideal. The usual rate cited has been Chairman Greenspan's favorite--the deflator for core personal consumptions (excluding food and energy). In September, that deflator was up 2.0% from a year ago, the top of the range and the same as the core CPI. We expect this inflation rate to creep upward, to around 2.5%, over the next year. Of the other likely candidates, the core CPI as measured by the new chain-weighted index is up 1.8% over the last year and the core market-based deflator (which includes only items that are actually priced rather than imputed) is up 1.7%.

The inflation rate is thus either at the top end or well within the likely target range. Moreover, the Fed is already raising interest rates. The question is when the Fed can stop. Both of the last chairmen (Alan Greenspan and Paul Volcker) began their terms by raising interest rates. Chairman Greenspan remembers that in his case it helped result in the biggest one-day drop in U.S. stock market history only two months after he took office. He would probably prefer to put the funds rate where he thinks it should be before he leaves office, thus leaving Chairman Bernanke no work to do and the freedom to move next in whatever direction he needs to.

The fact that the new Chairman will stop raising rates does not make him a dove. Rates will be, after all, up 350 basis points from June 2004. It will be time to stop and take stock before moving rates yet higher.

But if oil prices surge higher, rates may have to follow. The surprise so far has been how little of the rise in energy prices has spilled over into the core inflation rate. This was in part because wage increases have remained low, and productivity strong. In the 1970s, the jump in oil prices was associated with a slowdown in productivity growth; so far, this time productivity has remained strong.

The Kindness Of Strangers

The second risk for the new Fed chairman is the dependence of the financial markets on the inflow of foreign capital. The household saving rate has been negative for a record four consecutive months. The federal deficit, after narrowing in fiscal 2005, is expected to widen in 2006 because of the spending for hurricane relief. The gross national saving (treating all government spending as consumption) has dropped to a record low 10.2% of GDP in the third quarter.

Image1

On the other hand, private capital spending has remained relatively firm, at 16.5% of GDP. Admittedly, business spending has been a bit soft, but as we explained last week, this was offset by residential construction. The only way to balance saving and investment is the borrowing of 6.3% of GDP from abroad, which is the financial obverse of the current account deficit.

In the short run, the inflow of funds will continue. We were worried a year ago because the current account was being financed primarily by foreign central banks, but in recent months the financing has switched back to private channels. In the 12 months ended in August, there was an inflow of $811.5 billion in private capital, compared with only $148.5 billion in official inflows.

The private inflows are responding to interest rate differentials. The U.S. 10-year Treasury note is yielding 4.5%, not exciting, but far above the 1.4% available on equivalent Japanese paper or the 3.0% available in Germany. These flows will continue until foreign interest rates rise or investors become scared of the exchange-rate risk. The latter is the biggest problem, since that could force U.S. bond yields higher in order to reduce U.S. investment and attract more foreign inflows.

Foreign countries could be hurt more than the U.S. in this scenario, since they are depending on U.S. demand to keep their factories running. They could take a big hit as the value of their dollar investments drops in euros or yen. But that doesn't mean the U.S. wouldn't be hurt. The higher bond yields would choke off investment and cut productivity growth, slowing the U.S. economy into line with the weak economic performances of the other industrial nations.

Keep On Borrowing

The third possible tipping point is household debt. The average American household owes a record 124% of its annual after-tax income. Fortunately for the economy, consumers don't seem to care as long as they can afford to pay their debt service, and fortunately the debt service costs remain low thanks to the low interest rates.

But what happens when interest rates rise? Most Americans have locked in fixed-rate loans, and thus their payments won't go up. They should thus be able to continue to make their monthly payments, as long as they keep their jobs and their health. The problem will come when it is time to make the next purchase, and the car dealer wants 8% instead of the zero-rate financing on the old car.

The most serious impact is likely to be in the housing market. If mortgage rates rise moderately and gradually, as we expect, the first-time homebuyer will still find it cheaper to buy than to rent in most of the U.S. However, the trade-up buyer will be faced with having to give up his old 5% mortgage, and take out a new 7% one. That will sharply raise his monthly payment, and thus increase dramatically the cost of trading up. Many homebuyers may decide the old house isn't so bad after all.

Even without increases in interest rates, consumer spending has to slow. Consumers are now spending more than they are earning. There are clear problems with the measure of saving used in the national income accounts. It measures cash flow, and confuses assert changes and income. (For example, capital gains taxes should really be taken against stocks, not flows.) But although it is thus a poor behavioral measure, it does reflect the amount of current income households are contributing to financial markets, and the third quarter showed a negative (-0.8%) for the first time in the history of the quarterly data (since 1948).

Image2

Saving rates have gone negative before, but in all cases were pushed back positive by revisions. Although another such revision is possible, it can't be relied upon. It would seem that the saving rate has to move up, which means that household spending has to slow to below the growth of household income. That shift will remove a major support for the economy.

Much of the higher spending has been supported by home values. Last year, households took $320 billion out of their home equity by a combination of cash-out refinancings and home equity loans. If home prices stabilize, so that home equity values are no longer increasing as rapidly, it will become harder to tap that home equity. Moreover, higher interest rates will make the cash-out refinancing, and even home equity loans, much more expensive.

How Big Are The Risks?

It is always hard to estimate the magnitude of these risks because there are so many ways in which things can go wrong. To give some quantitative measure to the potential problems, we have created two scenarios. In the first of the pessimistic cases, oil prices double from current levels to near $120/barrel. The higher inflation keeps interest rates high, and prevents the Federal Reserve from loosening. Consumer confidence is damaged by the high oil prices and perhaps by the terrorist activity that sent oil higher.

In the second scenario, foreign investors become concerned with the stability and return of investments in the U.S., and cut back on these inflows, sending the dollar down. Bond yields in the U.S. must rise in order to fund the trade gap. The higher mortgage rates trigger a drop in home values, hurting household wealth. The Fed is unable to loosen because of the need to fund the trade gap, especially as the dollar sinks.

Image3

In both scenarios, the economy suffers significant damage. However, the two scenarios affect industries differently. In the first (high-oil) case, most of the damage is to the energy intensive industries, and especially autos. Travel and tourism also drop under the pressure of higher costs. Capital spending falls off because of the higher cost of capital and the weaker demand for new capacity.

In the dollar-crisis alternative, high interest rates hurt housing and construction most, but there is no outright recession. Consumer spending slows because of the drop in household wealth and the rise in consumer prices caused by the weak dollar. On the other hand, export industries pick up, as American goods become more competitive in the world marketplace. The higher long-term interest rates hurt investment and housing.

In the first scenario, the economy recovers after the recession. We assume oil prices come back down after a year, and as a result the economy comes back to its previous path. On the other hand, the stoppage in foreign inflows of cash is expected to continue, and thus the interest rates remain high for an extended period. However, home prices stabilize and the weaker dollar helps reduce the trade gap, boosting the economy.

In the second scenario, weaker investment slows productivity growth, and the economy is permanently depressed relative to the baseline. Unemployment rates stay low because more people are thus required to produce the same amount of goods.

What Would The Fed Do?

The scenarios are also affected by our assumptions about Federal Reserve policy. Incoming chairman Ben Bernanke has espoused inflation targeting, rather than the more eclectic approach of Chairman Greenspan. As a result, we expect him to be slower in cutting interest rates in the face of weaker growth, since in both scenarios the core inflation rate rises.

In our baseline projection, we assume that the Federal Reserve stops tightening at a 4.5% federal funds rate. In the high-oil scenario, the core inflation rate rises only slightly more than in the baseline (although the total inflation rate is much higher). As a result, the funds rate is essentially the same.

On the other hand, the dollar-crisis scenario, because of the sharp drop in the dollar and rise in import prices, produces a higher core inflation rate. The Fed keeps the funds rate high even after the economy sinks into recession.

Table 1 How It Could Go Wrong*

 

 

% change

 

2005

2006

2007

2008

Real GDP

3.6

3.3

3

3.1

  

High oil

3.6

2.9

0.4

3.5

  

Dollar crisis

3.6

3.3

2.2

2.4

Consumer spending

3.5

2.9

3.3

3

  

High oil

3.5

2.2

0.1

3.2

  

Dollar crisis

3.5

2.8

2.7

2.3

Equipment spending

10.9

9.4

6.2

6.2

  

High oil

10.9

8.7

-1.6

6.4

  

Dollar crisis

10.9

9

2.8

0.2

Exchange rate (MTP)

-2

-2.5

-5.7

-2.3

  

High oil

-2

-2.5

-5.7

-2.1

  

Dollar crisis

-2

-4.1

-10.1

-9.9

Productivity

2.7

2.2

1.9

2.3

  

High oil

2.7

1.8

0.7

3.5

  

Dollar crisis

2.7

2.1

1.3

1.8

 

 

Levels

Unemployment rate

5.1

4.9

4.9

4.9

  

High oil

5.1

5

6.1

6.4

  

Dollar crisis

5.1

4.9

5

5.1

Housing starts (mn)

2.1

1.9

1.8

1.8

  

High oil

2.1

1.8

1.5

1.5

  

Dollar crisis

2.1

1.8

1.7

1.5

Light vehicle sales (mn)

16.8

16.3

16.9

16.9

  

High oil

16.8

15.8

13.4

14.9

  

Dollar crisis

16.9

16.3

16.3

10.7

Bond yield (10-year)

4.33

5.22

5.79

6.32

  

High oil

4.3

5.2

5.8

6

  

Dollar crisis

4.3

5.8

8.3

10.7

Oil price ($/bbl,WTI)

56.9

58.5

49

45.2

  

High oil

57.7

90

120.8

71.7

  

Dollar crisis

56.9

58.5

49.1

45.5

S&P 500

1210.9

1293.7

1317

1405.8

  

High oil

1204.5

1261

1062.3

1145.6

  

Dollar crisis

1204.5

1207.7

935.2

721.4

*First line for each concept is the baseline.

 

S&P Economic Outlook

 

 

 

 

 

 

 

 

 

 

 

Nov-05

 

2005

 

2006

 

 

 

 

 

 

 

 

 

 

Q3

Q4

Q1

Q2

2002

2003

2004

2005

2006

2007

2008

 

 

 

 

 

 

% change

 

 

 

 

 

 

Real GDP

 

3.8

3

3.6

3.4

1.6

2.7

4.2

3.6

3.3

3

3.1

  

Consumer spending

3.9

0

3

3.8

2.7

2.9

3.9

3.5

2.9

3.3

3

  

Equipment investment

8.9

8.7

10.9

9

-6.2

3.2

11.9

10.9

9.4

6.2

6.2

  

Nonresidential construction

-1.4

6.5

33

24.3

-17.1

-4.2

2.2

1.8

13.5

-0.8

0.3

  

Residential construction

4.8

5.3

-5.4

-11.8

4.8

8.4

10.3

7

-3.8

-6.4

-2.4

  

Federal government

7.7

6.3

1.5

1.1

7

6.9

5.2

2.9

2.9

0.6

0.9

  

State and local government

0.6

3.2

1.4

1.7

3.1

0.7

0.4

1.7

2

2.4

1.4

  

Exports

0.7

7.3

6.9

6.2

-2.3

1.8

8.4

6.8

6.2

8.9

10.1

  

Imports

0

9.5

5

4.2

3.4

4.6

10.7

5.9

4.6

4.8

4.5

CPI

 

5.1

3.2

2.4

1.2

1.6

2.3

2.7

3.4

2.6

1.4

1.9

  

Core CPI

1.5

2.4

2.7

2.6

2.3

1.5

1.8

2.2

2.4

2.4

2.5

Nonfarm unit labor costs

-0.7

1.8

1.9

2.3

-1.1

-0.2

0.8

2.9

1.7

2.3

2.1

Nonfarm productivity

3.9

1.9

2.3

2

4.3

4.4

4

2.7

2.2

1.9

2.3

 

 

 

 

 

 

Levels

 

 

 

 

 

 

Unemployment rate

5

5

4.9

4.9

5.8

6

5.5

5.1

4.9

4.9

4.9

Payroll employment (Mil.)

134

134.3

134.8

135.4

130.3

130

131.5

133.6

135.6

137.4

139

Federal funds rate

3.5

4

4.4

4.5

1.7

1.1

1.3

3.2

4.5

4.6

5

10-year T-note yield

4.2

4.6

5

5.1

4.6

4

4.3

4.3

5.2

5.8

6.3

Aaa corporate bond yield

5.1

5.6

6

6.2

6.5

5.7

5.6

5.3

6.3

6.9

7.6

Mortgage rate (30-year conventional)

5.8

6.2

6.6

6.8

6.5

5.8

5.8

5.9

6.8

7.3

7.9

Three-month T-bill rate

3.4

3.9

4.3

4.4

1.6

1

1.4

3.2

4.4

4.4

4.8

S&P 500 Index

1224.1

1246

1278.7

1293.1

995.6

963.7

1130.6

1210.9

1293.7

1317

1405.8

S&P operating earnings ($/share)

19.42

20.04

20.65

21.15

46.04

54.69

67.68

76.88

83.01

85.88

88.59

Current account ($ Bil.)

-793.61

-855.47

-869.91

-891

-475.2

-519.68

-668.08

-806.59

-890.74

-888.61

-862.28

Exchange rate (major trade partners)

83

84

82

81

104

92

84

82

80

76

74

Crude oil ($/bbl, WTI)

63.21

61.5

60.75

60.08

26.11

31.12

41.47

56.92

58.45

48.98

45.2

Saving rate

 

-1.1

0.1

0.7

0.8

2.4

2.1

1.7

-0.1

0.8

0.7

1.2

Housing starts (Mil.)

2.1

2

2

1.8

1.7

1.9

1.9

2.1

1.8

1.8

1.8

Unit sales of light vehicles (Mil.)

17.9

15.7

15.9

16.2

16.8

16.6

16.9

16.8

16.3

16.9

16.9

Federal surplus (unified, $ Bil.)

-69.19

-105.63

-123.6

-26

-157.79

-377.07

-412.82

-318.62

-363.87

-301.02

-298.47

By David Wyss, Chief Economist, New York, Standard & Poor's


[The article is an abstract from RatingsDirect, Standard & Poor's Ratings web-based credit research and analysis system (www.ratingsdirect.com). To learn more, please click on About RatingsDirect.]

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