Rioting in Gaza

November 28 1994

Rioting in Gaza

November 28 1994



A sharp hike in U.S. rates could slow Canada down

Higher interest rates in the United States were the last thing that Standens Ltd., of Calgary wanted last week. The automotive springs manufacturer sells much of its production in the United States, and sales manager Bill Haniak says that the U.S. Federal Reserve Board rate hike will hurt his business on two fronts. As interest rates in both countries rise, Standens’s costs increase. In addition, higher rates will act as a disincentive to buyers who rely on credit, and their unease in turn will generally slow economic growth. Although Standens, the largest manufacturer of auto and trailer springs in North American, has had good sales in 1994, Haniak says that higher rates, along with a recent jump in steel prices, will cut into 1995 sales prospects. “We are worried,” he said.

“It’s definitely bad for business.”

Haniak is not alone in his concern about the prospects for his business. Jayson Myers, chief economist at the Canadian Manufacturers’ Association in Toronto says that 40 per cent of the country’s manufacturing production is now being exported to the United States.

And any slowdown there will be felt almost immediately across the border in Canada. Still, a slowdown is what the U.S. Federal Reserve Board was aiming for with its hike last week in the cost of borrowing. The federal fund rate jumped by three-quarters of a percentage point to 5.5 per cent. Not only was the increase—the sixth this year—bigger than the financial markets had expected, but

the board also hinted that there was still another increase to come. The board’s aggressive rate boosting is controversial: while Wall Street economists, who focus more on purely financial issues, support it as necessary to prevent the return of robust inflation, others, who concentrate on fundamental business conditions, worry that it will choke off economic growth.

With the country’s political environment more stable than it was before the Quebec election, and with the federal government’s commitment to cutting the deficit reaffirmed, economists predict that Canadian rates will not be

In Canada, where the economic recovery is much less advanced than in the United States, the rate hike has the potential to do even greater damage. Even so, Canadian financial markets initially reacted coolly, with some Canadian rates—the bank rate and some other short-term rates—edging upward slightly. forced up as much as U.S. rates—at least for the moment. “But it’s inevitable that we’re going to get higher rates,” said Sherry Cooper, chief economist at investment dealer Nesbitt Bums Economics in Toronto. “I don’t think the Fed is going to be satisfied until they cmnch the economy.”

In Washington, Alan Greenspan, chairman of the Federal Reserve Board, is being criticized for the Fed’s surprisingly aggressive antiinflation strategy. Although the board’s activi-

ties are usually ignored by the general public, demonstrators picketed outside Greenspan’s office last week, protesting that higher interest rates are killing jobs. The demonstrators were not alone in their concern. Although a majority of U.S. economists tend to support Greenspan, many say that the economy is in danger of slowing down far more than the board intends. Philip Braverman, chief economist with DKB Securities U.S.A. Corp. in New York City, says the reserve board is overreacting and that soon the

economy will show serious deterioration. “They feel the enemy is on the run,” said Braverman. “With inflation in retreat they think that now is the time to beat it for good. But they’re fighting the last war—replaying the last recession—even though conditions have changed.”

Braverman says that the board’s current strategy would have been appropriate for the recovery period after the 1981-1982 recession, when inflation remained persistently high. But, he says that it will not work now, when other factors, such as intense international competition, are keeping a lid on price increases. Instead, he says that interest rates have risen so much already that it is only a matter of time be-

fore their chilling effect shows up in the nation’s economic statistics.

Indeed, some economic indicators are already beginning to show serious weakness. Last week, U.S. housing statistics showed that construction starts had plunged five per cent in October, compared with September. Housing starts in the United States peaked at the end of 1993 when they hit a monthly rate of 1.6 million. By October, however, they had fallen to a seasonally adjusted rate of 1.4 million. Housing is one of the sectors most sensitive to ris£ ing rates. Noted Braver! man: “I’m afraid that it’s going to take a series of recessions before they learn the lesson that

inflation is no longer the problem.”

Meanwhile in Canada, the real estate market is even weaker. “It has slowed quite dramatically,” said Tom Alton, president of Bank of Montreal Mortgage Corp. in Toronto, “especially in the first-time buyer segment. When rates rise, they’re the first ones who get squeezed out of the market.” The good news, says Alton, is that Canadian rates may not rise much more. “I don’t see any great push to raise rates in Canada,” he said. “Our economy is much weaker,

and we have almost no inflation.”

Following the Fed’s rate increase, the Canadian dollar slipped just half of one percent to close the week at 73.10 cents, and short-term interest rates edged up about one-quarter of a percentage point. The inflation rate, running at about 1.5 per cent now, is only about half that of the United States. Furthermore, mortgage rates in particular are holding steady. “Hopefully, we can get by this time without having to raise mortgage rates,” said Alton. ‘The fiveyear rate is at 9.9 per cent right now. If it goes over 10 it has a bad psychological effect on the real estate market.”

He says that most mortgage customers are taking advantage of lower short-term rates,

running between 7.25 and 8 per cent for six months or one year. “Consumers are still going short,” said Alton, who recommends that strategy for most mortgage holders because he expects mortgage rates to remain relatively steady for the next year or two. There is even a possibility, he says, that long-term rates, which, in an unusual move, climbed much faster than short-term rates during the past nine months, may fall slightly next year.

But higher U.S.interest rates—and the economic slowdown that they are likely to cause— are particularly worrisome to the manufacturing industry. Myers, of the manufacturers’ association, says that the Canadian economy owes its recovery almost entirely to the growth in exports to the United States. With 40 per cent of the sector’s production going to the United States, a slowdown in that country would quickly be felt in the Canadian industry. “There’s no sign that domestic consumers are going to be stepping up to replace lost U.S. sales,” added Myers. “Many of them are sitting on mortgages that are greater than the selling price of their houses, so they are not rushing to start spending again.” In the United States, Braverman predicts a significant reduction in consumer spending early in 1995, “after the Christmas bills come in and they see the effect of higher rates on their credit cards.”

Higher interest rates are also bad news for governments with budget deficits. In Canada, every one-percentage-point increase in rates costs Ottawa another $1.7 billion in interest costs each year. Said Myers: “It makes [Finance Minister Paul] Martin’s job even tougher.” However, Surinder Suri, chief economist with London life Insurance Co. in London,

Ont., in a somewhat contrarian point of view, cites expectations about the U.S. government deficit, even more than inflation worries, as the force pushing up U.S. rates. Suri says that with the Republican election sweep earlier this month, and the presidential election now just two years away, financial markets are expecting the loosened political purse strings to push the U.S. deficit up. An increased demand for borrowing will push up interest rates. “There’s only a finite amount of capital in the world,” said Suri, “and much of it

is now going to the emerging nations—so it’s not surprising that the cost of money or interest rates has to go up.” On a more grassroots level, however, Standens’s Bill Haniak is openly worried about how the spring industry is going to weather the surge in rates. Said Haniak, who met with other industry members at an automotive convention in Palm Desert, Calif., just last month: “It wasn’t like the past few years when everyone was talking about going out of business. This year everyone was talking positively, there was growth in their business.” Suddenly the question has become, is that growth about to disappear?