Hamish McRae: Katrina helps blow US in direction of higher spending - and higher rates

The Fed knows it must rely less on data and more on anecdotal evidence
Click to follow
The Independent Online

On the one hand the Federal Reserve is continuing its "measured" rise in interest rates, on the assumption that Katrina, and perhaps now Rita, will not leave any lasting dent on demand. In real terms, interest rates are still very low and they would have to be above 4 per cent for them to be considered normal - the evident aim of the Fed. Nevertheless the rise has been criticised in the light of the pressure on consumers, in particular from higher fuel prices.

Meanwhile, there are clear signs of a downward shift in consumer sentiment. The well-regarded University of Michigan consumer confidence index has plunged and, as shown by the first chart, even before Katrina and the associated rise in fuel prices, retail sales had come off.

It may be that those weak August sales were distorted by a decline in car sales. The fall did come after two strong months. Nevertheless there is the practical reason why at some stage there should be a weakening of consumer demand, which is that the rise in house prices seems to be easing. As in the UK, there does not need to be a fall in prices to curb demand; merely an easing of their rate of growth cuts the borrowing capacity of consumers.

The Fed knows all this. Intriguingly, too, it knows it must rely less on data at a time like this, when a series of shocks are hitting the economy, and look instead at anecdotal evidence. But it has taken the view that it is wiser not to be diverted from its stated path. Why?

I suspect the answer comes in two parts. First and most obviously there are strong inflationary pressures. Producer prices (see next graph) are up 5.1 per cent year on year. Even taking out the impact of fuel and food they would be up about 2.5 per cent and, as the IMF notes, there may be further rises in the oil price in the pipeline, so to speak.

In fact, the rise in producer prices is at the highest level since the early 1990s. So it has to lean against inflation, all the more so since long-term rates have remained quite low and so to some extent blunt the edge of the rise in short-term ones.

The second part of the answer is the need to maintain international confidence in the US dollar and more broadly the country's financial position. Everyone knows about the current account deficit, which has continued widening - though the other deficit, the fiscal one, has closed up a bit in recent months. But the other side of that deficit - the flow of investment funds into the US - has attracted less attention. The right-hand graph shows how net foreign private-sector purchases of US Treasury securities have continued as strongly as ever through the past year. Much has been made of the potential wariness of the Japanese and Chinese authorities about increasing their official holdings of US debt. While the private sector retains its confidence in US paper, however, there is solid support for the dollar and the US will be able to cover its twin deficits.

I don't think the need to please foreign holders of US debt is explicit in any way in Fed discussions. But I'm sure it is at the back of the mind of Alan Greenspan, the Fed chairman, that a run on the dollar in the final months of his watch would not be the greatest legacy. So the Fed is carrying on with its intended policy irrespective of what is happening on the hurricane/energy front. Indeed you could argue that the need for a tighter policy is actually increased by these events.

There are two points here. The first is that all previous experience of natural disasters is that they may cut demand in the short run but are either neutral or positive in the long run - positive, that is in macroeconomic terms, not in human or local terms.

The second point is that Katrina, and maybe now Rita, will widen the fiscal deficit. It is difficult to get any handle on the figures but it is clear that much of the bill will be carried by the Federal government. That will be borrowed: we do have the assertion that there will be no tax rises to pay for the damage. Conclusion: fiscal policy will continue to be expansionary.

That is important, for what matters in terms of immediate impact on demand is not so much the level of the deficit, but changes in that level. You don't need the Federal deficit to come down much to take demand out of the economy. As noted, it has actually been declining for most of this year. Expect that decline to be reversed.

So what we will get from the US is an increasingly expansionary fiscal policy offset by an increasingly restrictive monetary policy.

I find that somewhat troubling. There is the underlying concern about the two deficits, as reflected by the latest IMF report, which uses the R-word for the first time. Recession. While the world financial markets saw some prospect of the deficits eventually narrowing, they have been prepared to fund them. Besides, where else does the money go?

So, in the short term, higher interest rates will continue to attract global funds. But higher rates will also gradually trim growth, and lower growth usually makes a country less attractive for investors. My worry is that this twist, of a stronger fiscal boost but more monetary restriction, will be less stable than the previous combination of a very gradual tightening of fiscal policy coupled with more restrictive money. You could persuade yourself that things were sort of heading in the right direction. Now that is harder to do.

Global growth is still strong at the moment, with - of course - China and India contributing along with the US. The great economic issue, almost the only one that matters, is whether we can come off the growth curve in a gentle, measured way. If we can, then this expansionary phase will carry on for some while, albeit at a somewhat slower rate. If we fail to make the adjustment gradually, the possibility of that R-word becoming reality increases.

So the stakes are high. I'm sure the Fed was right to continue increasing rates, just as it was right for the Bank of England to pause a while before making another cut. US consumers have to be made to tighten their belts but somehow they have to be persuaded to do so slowly and carefully. It is a balancing act that has been made all the more difficult by the ravages of the hurricane season.

Comments