Warning lights are flashing in the US: a slowdown is on the way

ON a global balance in growth which looks unsustainable
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The Independent Online
THIS may turn out to be the week when the US at long last starts to push up interest rates.

The Federal Reserve has been hoping for some time that the US economic boom would peter out of its own accord, but the most recent figures last week suggested that things were still running along pretty fast. Growth in the first quarter of the year was running at an annual rate of 4 per cent despite falling exports to East Asia, and unemployment fell to 4.3 per cent in April.

Most market forecasts do now suggest a slowdown, but were US rate policy to be determined solely by domestic considerations there is little doubt that rates would be going up. In fact they would have gone up long ago.

The main issue - in reality the only issue - has been whether the East Asian crisis is so serious that the US would be unwise to jack up rates just at this time. It has been argued that even a quarter percentage point rise in US rates would lead to a further East Asian meltdown.

Eventually, too, the decline in demand in East Asia ought to slow growth in the US. On the other hand it can equally be argued that East Asia is pretty adept at the meltdown game anyway and pre-empting a rise in US inflation is a more necessary global goal. If rates were put up a bit now, they could always be cut later if and when the fall-off in demand hits the US economy.

Anyway, we will see: there is the regular two-day Open Market Committee meeting starting tomorrow, which has to make the call. Trying to guess which way it will jump from 3,500 miles away is not a very sensible procedure; in fact it is not very sensible from any distance - not that that has stopped the market attempting to do so.

But it is sensible to be prepared. Think global, rather than just US, and have a look at the long graph on the left. This shows the global output gap since 1970, that is the extent to which output figures for 40 of the main countries around the world have diverged from their sustainable growth paths.

Three things stand out. Most obviously, we are now very close to global balance, though this masks the fact that some places (like Japan and much of Continental Europe) would be below the line with excess supply, while others (particularly the US) are above it with excess demand. Second, the amplitude of the waves has gradually diminished since the 1970s: the lines still go up and down, but the swings seem to be smaller. And third, unless something utterly remarkable has happened, the swings will continue, so that at some stage soon we will climb above or dip below again.

Even if the world's monetary authorities had perfect judgement, which they don't, and the world economy responded swiftly and effectively to changes in policy, which it doesn't, the present balance is not sustainable. Even if you believe that macro-economic management has been getting better (and falling inflation world-wide suggests it is), there has to be an element of fluke, in that one bit of the world which is up should happen to be offsetting the rest which is mostly down.

That won't continue. It can't: at some stage countries like Japan have to achieve a recovery or something really dreadful will happen, while at some stage the US will dip back towards its historic level of capacity utilisation. The instability of the US position is highlighted in the right hand graph, which shows the relationship between the growth of the US broad money supply, M2, and the boom on the stock market as measured by the S&P 500 share index of large companies.

You don't need to be an expert in the intricacies of the US monetary aggregates to be concerned about this link. One of the main reasons that money supply has been rising rapidly is the growth of money market funds, which accounts for about one-third of the recent growth. The International Bank Credit Analyst team, which drew attention to this link, reckons that there are two possible explanations for it. One is that the rise in share prices has encouraged people to take some of their profits out of the stock market and stuff these into money market funds. The other is that the surge in wealth associated with the bull market has boosted the demand for ordinary liquid assets and one popular way to hold such assets is money market funds.

Actually I don't think it matters terribly why Americans are putting money into these funds; the fact remains that they are building up assets which can quickly be converted into spending power if they so wish. There is a lot of dosh sloshing around. The data is flashing a warning light, and it will continue to flash the warning light whether or not the Fed pushes up rates this week.

The conclusion that flows from this is that one way or another the US economy is going to slow down. It is still perfectly possible that US interest rates will remain on hold and the economy will slow of its own accord later this year. It is equally possible that there is going to be some sort of discontinuity, with rates going up and that rise stopping the economy. But slow it will. That is bound to happen, for countries' economies do not grow faster than their trend growth for ever.

So it is not being apocalyptic to say that at some stage in the next 18 months the US will move into a phase where it grows below trend and where unemployment starts to rise. It is simply common sense to acknowledge that the economic cycle still exists, albeit possibly in a more benign form. The Fed's decision seems important and of course for anyone involved in the markets it is. But for the rest of us all we need to know is that somehow the US economy has to come off its present unsustainable growth path, and it is going to be somewhere between slightly uncomfortable and very uncomfortable for all of us when it does so.