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Corrrection will be a painful process

Corrrection will be a painful process
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First Published: Sat, Nov 24 2007. 12 39 AM IST
Updated: Sat, Nov 24 2007. 12 39 AM IST
The US Federal Reserve’s revelation that it now believes the long-run growth limit of the US economy to be around 2.5% reverses a decade of optimism.
Since Fed chairman Alan Greenspan declared to Congress in July 1997 that he thought productivity had undergone a secular improvement, the Fed has assumed an underlying US growth rate of 3% or more. The result has been excessively loose monetary policy. The Fed’s new more sober approach is to be welcomed.
In the decade before the Fed stopped reporting the figure in March 2006 because it said it costs a lot to collect the data but doesn’t provide significantly useful information, M3 money supply grew 8.2% annually, compared with 5.2% annual growth in nominal gross domestic product (GDP).
The Fed justified this laxity by the supposedly higher growth potential of the US economy and by the quiescence of inflation. We now know that the economic and technological changes since 1995 brought the world economy huge new ­lower-cost sources of supply for goods and services in China and India, together with other low-wage emerging markets.
This has suppressed inflation, and the Fed’s easy money policy, followed by others, has led to a worldwide explosion of credit and a series of stock and asset bubbles.
If the Fed comes to take a less roseate view of US growth potential, it must keep interest rates higher, because the “output gap” from full employment will be smaller. Imported inflation may also be a problem that forces interest rate rises, since higher inflation and currency strengthening have recently become apparent in both China and India.
Higher interest rates and lower money availability will deter bubbles, as interest rate spreads will remain more conservative and hedge funds and other speculators will find it unprofitable to leverage themselves so highly. The result will be less bubble creation—a most wholesome development.
Regrettably we must still pay the price for the Fed’s over-optimism of the last decade. If the cost of capital has been too low, then asset prices of both stocks and real estate are likely now to be much too high.
The correction process will be painful but then, reality always is.
Martin Hutchinson
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First Published: Sat, Nov 24 2007. 12 39 AM IST