The Nikkei Financial Daily (Market Eye Column). , 12th October 2006
Opinion seems to be divided between those who expect a US recession and those who fear inflation. The distinguished American economist Henry Kaufman holds the second view. He draws attention to the massive expansion of credit and to the fact that it is still readily available at attractive rates. This leads him to forecast creeping inflation and to worry that the Federal Reserve will not take adequate steps to break the trend. Those who fear recession are concerned about money supply and house prices. The growth of the former has slowed and the latter seem to be heading down.
A key difference in the two forecasts lies in the different emphasis placed on money and credit, where the trends are very different. In the three months to August, commercial and industrial loans grew at 18.2% p.a., while money supply, on its M2 measure, grew by only 4.2% p.a.
While most economists agree that money supply and inflation are related over the long-term, there are widely different views as to whether monetary data provides any guide to the shorter term outlook.
One way that money affects the economy is through asset prices. When it’s abundant it drives up asset prices, as it did during Japan’s bubble in the 1980s and over the past decade or so in the US. It is reasonable to expect a recession in the US if money supply slows to the point where there is a sharp fall in house and share prices. Neither of these has, however, yet occurred.
Sceptics also point out that the current rate of growth is not that slow and if the rapid growth in money over the past decade is considered, rather than its more recent deceleration, then it would be more reasonable to fear inflation than imminent recession. Indeed, as measured by the CPI, the US is already suffering from a rate of inflation of 4%, which is about double the rate that central banks usually like to target.
The problem for the Federal Reserve is that asset prices of all sorts are high relative to incomes. If, as seems likely, they must come back to a more normal relationship, then either nominal asset prices must fall or inflation must pick up. I doubt whether the Fed will willingly tolerate the latter. In due course, therefore, asset prices are likely to fall and a US recession will then be difficult to avoid.
History of course suggests that the US is virtually certain to have a recession some time. The question is whether inflation will pick up before then. At the moment the weakness of oil prices makes a pick up in the consumer price index over the next few months unlikely. This is not necessarily the case, however, for the measure of inflation that the Fed has chosen to target, which excludes energy and food. This has continued to creep up from 2% p.a. at the beginning of the year to 2.5% in August, which means that, if the economy is weak, it will be more difficult than usual for the Fed to respond to early signs of economic weakness by cutting interest rates.
Prices tend to respond more readily to changes in demand than wages. As a result, when economies slow it is usual for wages to rise relative to GDP and for profits to decline. Thus, by the time that the US economy has slowed enough for the Fed to meet its inflation target, profits are likely to have fallen.
Whether or not this leads quickly to recession depends on several different factors, which include how fast household savings rise, whether companies keep boosting their investments and whether foreign demand is strong enough to bring the trade deficit down.
My own expectation is that we are moving slowly rather than rapidly towards a US recession. Household savings have fallen hugely over the past 20 years, but Americans do not readily reduce their living standards. A slow but steady increase in the rate of savings should allow consumption to rise slowly and this seems more likely than an outright fall.
Consumption amounts to 70% of GDP and, if it grows even slowly, an outright recession will be avoided provided companies keep investing and foreign demand is strong. At the moment the signs are quite encouraging. Demand seems to be picking up in the rest of the world and this will be helped by the fall in the oil price.
Weak growth and falling profits seem at the moment more likely for the US in 2007 than an outright recession.