The White House should challenge the Fed's rate hike rationale

The U.S. Federal Reserve says that the “impetus” to economic growth will be “wearing off … in the next year or so,” while continuing to insist on the need for tightening credit conditions.

Media reports are amplifying the confusion with stories that the Fed is worrying about the impact of tight labor markets on inflation in a slowing economy.

Looking at that mishmash, President Donald Trump might be forgiven for turning to his real estate friends to see growth implications of rising credit costs and the collapsing housing demand.

American residential investments virtually stagnated at an annual rate of 0.6 percent in the first three quarters of this year, after a sharp slowdown to a 3.4 percent growth in 2017.

That’s a serious jolt to private consumption, because a slowdown of housing demand always triggers a decline in sales of consumer durable goods, popularly known as the “big-ticket items,” such as furniture, home furnishings, kitchen appliances and cars.

Consumer durables account for nearly 40 percent of all goods purchases in the U.S. economy, and their annual growth rate in the first three quarters of this year was a meager 1.4 percent.

And the worst is yet to come as the cost of mortgage financing continues to edge up. The 30-year fixed-rate mortgages now stand at about 5 percent, more than 100 basis points above the year ago.

That has to be watched carefully. Residential investments and private consumption are the key interest-sensitive components of aggregate demand: They represent nearly three-quarters of American GDP.

Those two variables are driven by employment, real personal disposable income and the cost of credit.

Here’s what that does: The U.S. now has a fully-employed economy, and the after-tax inflation-adjusted income is growing at a 3 percent annual rate, a slight improvement compared with 2.6 percent for last year as a whole. That means that the slumping housing demand must be mainly, or solely, attributed to rising mortgage costs.

What happens when three-quarters of the U.S. economy hits a rough patch, compounded by the relentless import penetration of U.S. markets by Asian and European producers? Will American companies have an incentive to build larger production capacities in their shrinking domestic markets?

Clearly, the answer is no. And there goes another 14 percent of America’s GDP — the share of business investments in the country’s demand and output.

Add it all up, and the rising credit costs, plus soaring imports, are directly hitting 90 percent of the U.S. economy.

Trump is familiar with both problems. He likes low interest rates because, he says, he has “always done well” during periods of inexpensive and widely available credit flows.

He may be less familiar with trade problems because his foreign competitors had little, if any, access to reshaping the New York skyline and building America’s prestigious golf clubs. Still, Trump knows enough to call systematic half-a-trillion, and rising, annual trade deficits a big “rip-off” of the American economy.

It is reasonable, therefore, to expect that the Fed would be basing decision about rising interest rates on credible evidence, and structural analysis, of accelerating inflation — the only binding constraint on U.S. monetary policy.

At the moment, the Fed is just mentioning inflation in passing. They are apparently convinced that their arcane PCE (personal consumption expenditure index less food and energy) inflation gauge, presently at the policy target of 2 percent, will stay there over the relevant forecasting horizon.

So, Trump should challenge the Fed to show the case for rising inflation, and ask them whether a central bank managing an appreciating currency is supposed to keep raising its interest rates.

On trade, Trump should do a quick deal with Germany, i.e., a German-run European Union. Germany’s trade surplus accounts for nearly half of the EU’s surplus on American trades. Trump should put aside his animus, and hold the nose to torrents of insults from German media, to clinch the only trade deal he will do in the foreseeable future.

Yes, a trade deal with China is a long shot, as you can see from openly confrontational speeches delivered last week at the APEC (Asia-Pacific Economic Cooperation) meeting in Papua New Guinea by the U.S. Vice President Mike Pence and China’s President Xi Jinping.

Only the naive sinologists can talk about a trade deal in the middle of a total impasse about: (a) structural issues in bilateral trade and investments, (b) Taiwan arms sales and implicit support for its sovereign leanings, (c) China’s contested maritime borders, (d) inter-Korean relations, and (e) the management of a competitive and transactional “cooperation.”

America’s rising credit costs have overpowered growing employment and significant real disposable income gains to cause slumping housing demand. That always leads to declining sales of consumer durable goods and a depressive impact on three-quarters of the economy.

On top of that, a strong import penetration, helped by the rising value of the dollar — which is equivalent to an import subsidy and an export tariff — kills the incentive of American companies to invest in expanding their production capacities.

That’s how rising interest rates begin eroding 90 percent of America’s aggregate demand.

The Fed should show an accelerating inflation as a rationale for rising credit costs. Also, an excess world demand for the dollar indicates its scarcity. Does it make sense, then, to increase the dollar shortage, and its relative price, by further restricting the dollar supply?

Trade deficits are also a powerful drag on U.S. economy. For quick results, Trump should make a deal with Germans, the chiefs of their EU realm.

And while he’s at it, Trump should tell the Germans to lay off Italy’s 2019 budget and work, instead, on a fiscal stimulus of their own to rescue their faltering economy. Berlin should do that through stronger domestic demand rather than taking purchasing power out of Italy, and the rest of Europe, with huge trade surpluses.

More generally, Washington should make sure that Germany stops messing up the European economy. Europe takes a quarter of U.S. exports, which are currently growing four times faster than U.S. sales to China.

Once he settles trade issues with Europeans, Trump can go toe-to-toe with China. That of course is not the optimal way to proceed. It would be much better to hold China to its standing offer of a “win-win cooperation.” Sadly, however, acute problems with Beijing seem to have gone well beyond the explosive and unsustainable bilateral trade imbalances.

Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York, and taught economics at Columbia Business School.

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