Column

AND THE LIVING IS QUEASY

It may be summer, but when the Fed sneezes the world can catch a cold

DONALD COXE July 19 2004
Column

AND THE LIVING IS QUEASY

It may be summer, but when the Fed sneezes the world can catch a cold

DONALD COXE July 19 2004

AND THE LIVING IS QUEASY

Column

It may be summer, but when the Fed sneezes the world can catch a cold

DONALD COXE

THE LAST DAY of the fiscal second quarter was also the first day that the Federal Reserve Board’s powerful open market committee raised interest rates since the U.S. experienced the twin shocks in 2001 of a tech bubble recession, followed by 9/11. Four years is a long time to keep the monetary spigots open.

As much as it may infuriate America-haters, the Federal Reserve is still the world’s most important central bank. That’s not just because the U.S. is still the world’s most important economy. It’s because of a side effect of those massive trade deficits the U.S. has run

for decades. Many of the trillions of dollars paid to foreign suppliers were converted into the suppliers’ currencies, but other trillions were held as U.S. dollars in accounts abroad, mostly in Europe. Those deposits, with accumulated interest, came to be known as Eurodollars, and have long been the most important source of short-term borrowing for businesses across the globe. When the Fed changes its rates, thousands of banks around the world follow suit. But this year, Eurodollar rates started climbing months before the Fed made its move, because the money markets concluded the Fed would have no choice but to raise rates in June. So Eurodollar holders and their banks did the Fed’s foreign work for it.

Not that raising the rate, called the federal funds rate, from one per cent to 1.25 per cent is a big deal in itself. The Fed would have to get its rate well above two per cent before it would have real impact on businesses’ borrowing decisions. Since almost nobody running a business can ever remember money being so cheap, what the Fed did last month was a mere bagatelle. But it’s a start.

THE WORLD economy will set records this year. What’s unclear is how North America will do if global growth is taken up largely by China, India, Japan and Brazil.

Once the Fed starts tightening, it usually keeps raising its rate until one (or both) of two things happens: either the economy slows down enough to scare the Fed, or inflation rates fall far enough to stop scaring businesses and consumers. What the Fed and other central banks learned from the hideous experiences of the 1970s was that inflation has to be stopped before it gets deeply entrenched in the economic system and in people’s psyches. Inflation always

begins with excessive monetary creation. Once it reaches the stage that everyone is getting cost-of-living allowances in addition to hefty wage increases, taming it involves not only a mea culpa from the central bankers who spawned the horror, but a deep recession and years of restraint. (Contrary to business propaganda, inflation isn’t born in union wage gains, as long as free markets operate. If workers get excessive wage gains from supine managements, those workers become unemployed when consumers refuse to pay up for their expensive output. Think about the high-paid Air Canada and United Airlines pilots who are being forced to give back some of their gains and whose jobs have become vulnerable in the face of low-cost competition from Westjet

and Southwest. (The wage gains that drive inflation come largely from the government or heavily regulated sectors.)

So what happens now? Today’s soaring oil prices initially raised inflation rates, but they also weaken the economy, thereby reducing inflation. That’s because consumers have less to spend because they gave at the pumps. The Fed itself hinted at that twostage relationship in its policy statement released along with the June 30 announcement of the rate boost.

A recent Gallup poll showed that American consumers believe inflation risks are

worse than the Fed or Wall Street economists assert. To the extent that inflation is a state of mind, the Fed must convince those doubters that it remains vigilant. However, other surveys show that American consumers are more optimistic than the Fed about the economy as a whole. The heart of consumer confidence polls is people’s optimism or pessimism about their jobs. Right now they feel that, even if they lose their job, getting a new one will be relatively easy.

The U.S. stock market has dropped back to where it was last Christmas, despite six months of soaring corporate profits. In issuing her bullish economic forecast, Diane Swonk, the ebullient chief economist of Chicago-based Bank One, says, “It doesn’t get any better than this.” Maybe the stock market agrees, but not the way she means. Maybe the best news is already behind the American economy, and the real action is moving abroad.

The world economy will set records this year. What’s unclear is how well North American economies will perform if a disconcertingly large percentage of global growth is taken up by China, India, Japan and Brazil. Historically, by the time the Fed starts tightening, the U.S. economic recovery is well-established. If the Fed tightens the right amount and at the right times, the economy slows, inflation eases, and then the economy starts running again without the excess baggage of inflation. That’s expecting a lot from a committee. Like the rest of us, the Fed has to deal with conflicting economic data. After three months of booming U.S. job growth, the economy suddenly softened in June. A hiccup? Evidence that high oil prices are really starting to bite? Time will tell.

Summertime, and it’s suddenly queasy— for the committee and U.S. investors. Ufl

Donald Coxe is chairman of Harris Investment Management in Chicago and of Toronto-based Jones Heward Investments. dcoxe@macleans.ca