Pavlovian dogs and the Fed

Pavlovian dogs and the Fed
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First Published: Tue, Sep 11 2007. 12 20 AM IST
Updated: Tue, Sep 11 2007. 12 20 AM IST
The penny appears to have dropped. On Friday, the US reported that total employment shrunk by 4,000 in August. More importantly, there were substantial downward revisions to previous estimates of job creation in June and July. Average monthly job creation in the last three months is now 44,000. Pre-revision and for the three months ending July, the average monthly job creation was 135,000. However, the unemployment rate remained unchanged at 4.6%. That is easily understood by noting that the size of the labour force shrunk a bit. That happens when people drop out of the labour force, actively stop looking for a job and, instead, take a long-overdue vacation. The Pavlovian dogs are out with saliva dripping in anticipation of rate cuts by the Federal Reserve as the decks are more or less cleared for them to lower their target for the Federal funds rate to 5.0% or lower on 18 September.
The Fed has not been short on advice on whether it should lower the Federal funds rate or not. Many have contended that the crisis of confidence and scarcity of information on the quality of balance sheets in the financial industry in America and Europe are self-inflicted and that the industry should sort itself out with some liquidity support from central banks where needed. Relaxation of the monetary policy is to be attempted only if macroeconomic conditions deteriorate in the US. The August employment report suggests precisely that and hence the near-certainty that the Fed will lower the target Federal funds rate on the 18th of this month. No surprise then that the US dollar is weak and gold is strong. Expect to see more of it in the future.
However, Fed rate action would not solve the problem. What we are now faced with is not just a “simple” downturn in the economic cycle that could be addressed by lower interest rates. As Moody’s put it, the problem is one of information crunch and not credit crunch. The economic downturn will complicate it further. Josef Ackerman, global CEO of Deutsche Bank, asked his fellow bankers to come clean on the hidden skeletons in their closet and in other closets they had set up over the years (called Structured Investment Vehicles, or SIVs). The fact is that the current funding problems of the SIVs set up by banks now devolve on the banks, exposing the hollowness of setting them up outside the bank balance sheets in the first place.
Banks are reluctant to disclose more because they are fearful of the backlash from the investor community which has already been swift, and second, because of the prisoner’s dilemma—no one wants to be the only institution owning up to sins. Mea culpa has to be collective.
To be sure, for the present crisis in the financial sector to morph into an entrenched economic downturn, the American consumer has to pare back spending. The demise of the American consumption juggernaut has been predicted many times in the past with disastrous results. Perhaps, this time it is different. Hope springs eternal that American households will rediscover the joy of saving for a rainy day. Conditions are propitious now.
One, there are no more asset markets left for the Federal Reserve to reflate. Two, consumption has been supported by home equity withdrawal (HEW) in the last few years. Home equity increases every month as instalment payments are made by the borrower and then the borrower borrows against the accumulated equity! Such equity withdrawal is not going to be possible if prices of houses decline or if payments are not kept up. Of course, usually, the effect of HEW on consumption lasts for several quarters. HEW was significant right up to the end of the second quarter. Therefore, a significant slowdown in consumer spending can be expected by the middle of 2008 at the latest.
If a recession/substantive economic slowdown in the US arrives in 2008, then what happens to emerging economies? Many reckon that emerging market economies would be relatively unaffected. That appears to be largely based on hope than on reality. Linkages are tighter than before, particularly in Asia, both on the macro and on the market side. Investors are still in denial on this and it is causing them to buy Asian stocks on dips when they should be selling into strength. In a recent lunch hosted by JP Morgan, Moody’s has observed, “The linkages between a potential US current account adjustment and China’s growth prospects are deemed significant and, in turn, China’s growth outlook and that of commodities would have ramifications on other emerging market credits.” That is pithily put.
Investors should take a leaf out of former prime minister Narasimha Rao’s book and practise masterly inactivity, after converting their securities holdings into cash and gold. That would serve them well over the next two to three years.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at baretalk@livemint.com
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First Published: Tue, Sep 11 2007. 12 20 AM IST