Why has the US economy slowed so much?

"The Federal Reserve may yet live to regret last week's decision to cut rates before it is certain that the build-up of inflationary pressure has been decisively scotched"

Just six months ago, the world economy was booming. In particular, the United States was growing at an annualised rate of over 5% and seemed to have unstoppable momentum. As recently as February, the Federal Reserve raised short term interest rates to 6%, thus completing a 12 month period in which rates exactly doubled.

How different everything now looks. Europe continues to expand, but Japan has slipped into yet another leg of its prolonged recession, and something very odd has happened in the United States, where activity has ground to a complete halt in the second quarter. It might be argued that there is nothing very surprising in an economy which slows down sharply after its central bank has doubled the rate of interest in less than a year. But as the graph shows, monetary policy was so exceptionally easy when the Federal Reserve started to act that its modest tightening simply took real short term rates to around their average level for the past decade, something which should not have led to any threat of a recession.

Based on previous experience, short rates should have needed to rise well above the growth in nominal GDP (around 6-7%) to slow the economy; in fact, a simple average of previous cycles suggested that rates needed to go up by at least 5%, thus reaching 8% at the peak, in order to puncture the upswing. In other words, the economy has slowed with a much smaller dose of monetary medicine than is normal. Very broadly, there are two possible explanations for what has happened, and it is crucial (though very difficult) for policymakers and investors to distinguish between them.

The first explanation is that the responsiveness of the economy to higher interest rates has become much greater in this cycle than before. If this is true, the tightening in monetary policy since February 1994, which appears on the surface to have been modest, may have gone too far, tipping the economy into an unexpected recession. The upshot would be that interest rates are now headed downwards for a while, and that the bond market rally seen so far this year is justified.

The second explanation is that a series of temporary shocks in the first half of this year has added to the impact of higher interest rates, and has for a while braked the growth in demand. In response to this, firms have reacted more quickly than usual to rising inventories, and have cut production drastically to prevent a build up of unsold goods. The implication is that activity could pick up again quite sharply once inventories are at desired levels, eventually requiring renewed monetary tightening by the Federal Reserve.

So which explanation is the more likely? Bill Dudley and Ed McKelvey at Goldman Sachs have examined several possible reasons why the economy may have become more sensitive to interest rates than before, or why monetary policy may be tighter than is implied from simple calculations of real interest rates.

First, debt ratios for households are higher than they were for most of the post-war period, which might have made the economy more vulnerable to increasing rates. But debt is now considerably lower than it was in the last economic cycle. And most economists forget that households also hold far higher levels of short-dated assets than they used to, so that in net terms their incomes are now actually improved by higher interest rates. Second, households are no longer allowed to deduct interest payments on consumer credit from their tax bills, so Uncle Sam does not cushion them from higher borrowing rates. This is true, but the overall cost of lost tax deductibility to the US consumer each year is minuscule - perhaps about $2-3 billion a year in a $7,000 billion economy. Third, monetarists often point out that bank reserves are now shrinking by about 4% a year, which they believe is an indication that central bank policy is tighter than implied by the level of real interest rates. But this ignores the fact that bank reserves are not restricted as a policy instrument by the central bank. Instead, they simply adjust passively to the private sector's holdings of different types of bank deposits and other financial assets.

As the private sector shifts out of demand deposits into assets with higher returns, the banks' requirement for reserves automatically declines. But this does not represent a monetary tightening by the central bank, and does not restrict the ability of the banks to extend credit. In fact, bank lending has accelerated in recent months, and is now rising at an annual rate of around 7%.

Two other points are also relevant to the debate on monetary policy. If monetary conditions were really tight, would share prices have surged, and the dollar plummeted, in the way we have observed this year? And what about the fact that interest rate ceilings are no longer operative? Prior to the early 1980s, the power of interest rates to impact the economy was enhanced by the fact that housing activity collapsed completely when market interest rates rose above the "ceiling", since this switched off the institutions which provided housing finance. This automatic switch is no longer available, so credit needs to be rationed entirely by price - which in turn implies that interest rates may need to go higher than before to slow economic activity.

For all these reasons, the "monetarist" case, though powerfully gaining ground in recent months, seems to lack complete conviction at this stage. The alternative case is the following. Clearly, rising short term rates did have some impact in slowing demand last year, especially since they were accompanied by higher bond yields as well. The latter are now increasingly important in determining the extent of refinancing activity in the mortgage market, which can shift the timing of spending on housing and other durables.

Just as this adjustment to higher rates was underway, the economy was hit by two temporary shocks. The Mexican crisis reduced US exports by about $20 billion a year, which cut the annualised growth of real final sales in the economy by about 1% early this year. In addition, the tax refund season fell behind the normal schedule, leaving consumers temporarily worse off to the tune of about 1.2% of disposable income in March and April.

Neither of these factors will depress the economy any further, and the delayed tax refunds will in fact boost spending during the summer. But companies are now responding aggressively to prevent any unwanted build- up in inventory, so GDP may be roughly flat in the second quarter, even though final sales could grow at an annualised rate of about 2%.

Once this inventory adjustment is over, the economy should on this explanation start to expand again under the impetus of lower interest rates, especially in the bond market. This seems marginally the more plausible of the two explanations. If it is right, the Federal Reserve may yet live to regret last week's decision to cut rates before it is certain that the build- up of inflationary pressure has been decisively scotched.