The conundrum is back

For all the excitement surrounding the surprise strength in the June durable-goods orders report that showed a rebound, the non-residential investment on equipment and software declined in the second quarter. So much for resilience of corporate investment. With the best profit growth in several decades, the US had a shockingly anaemic investment spending in 2002-07. No surprise, therefore, that in the second quarter of 2008, there was no stamina for it.

Investment in non-residential structures rose rather significantly (0.5%). One must question the wisdom of undertaking those investments. Non-residential structures involve hotels, office buildings and shopping malls. The latter two are flat while there has been a boom in the construction of hotels. With remarkable timing, additional hotel-room capacity will be released at a time when the worsening economy means reduced business and recreational travel. In other words, just as residential investment spending bottoms out and ceases to be a drag on GDP growth, non-residential investment spending would take its place.

Unsurprisingly, Goldman Sachs’ new report argues that the second half US economic slowdown will be worse than anticipated. Anticipated recovery is now pushed out to the second half of next year. They have begun the procession. Others will follow.

As for the most recently released July employment report, while the extent of job losses was slightly lower than expected at face value, the amount of hours worked in the economy continued to decline from the second quarter. Further, while the reported unemployment rate climbed to 5.7% from 5.5% in June, an alternative measure tucked away in one of the tables shows unemployment at 10.3%. The difference between the two measures is simply the cumulative outcome of statistical changes made by the US labour department over the years that make the reported unemployment rate look a lot lower than what it really is. In addition, the proportion of industries — both manufacturing and non-manufacturing — adding workers has shrunk to lows not seen in decades.

Naturally, all this raises questions about the prospects of the US federal funds rate. Some contend that the US Federal Reserve would not cut interest rates as the previous cuts have not really worked.

For example, Merrill Lynch has an interesting chart on how the private sector interest rate (an equally weighted average of the interest rates on mortgages, automobile loans, home equity loans, inter-bank rate and few others) has remained little changed since the Fed first began cutting interest rates in August 2007.

With the slump in demand for credit and the Fed cutting rates aggressively, interest rates in the economy should have nosedived. Instead, they have changed little from one year ago. The explanation is not difficult to find. Lack of trust fully accounts for it. No one trusts the counterparty enough to align the cost of capital closer to the policy rate. The real remedy, of course, is to shrink supply of credit. That would mean closure of weak, failed and dangerous institutions. Confidence would return to the remaining participants. The US is nowhere near that path. Industry and regulators are engaged in subterfuges of all kinds to keep all afloat. Surely, the bottom or the end must be nowhere in sight.

Further, the delightful symmetry in the private sector interest rates not reacting to rate cuts must be pointed out. One of the reasons that longer maturity interest rates in the US — be they treasury yields or mortgage interest rates — did not react to interest rate increases by the Fed from 2004 to 2006 was that central banks in the developing world were buying these assets and thus held them down somewhat abnormally. Alan Greenspan termed it a conundrum. The conundrum is back now. With policy tightening, market rates did not go up. We had a boom. With policy easing, we do not see market rates falling. We are having a bust.

Well, that does not mean that monetary policy would not be eased further by the Fed. There will be a clamour for lower rates in the fourth quarter, if not earlier. Watch the federal funds rate being lowered to 1.5%. The curiosity lies in seeing in how much lower it would go. Those who argued that the US was different from Japan might still be right. The US economic stagnation could be worse than Japan’s.

In the last one year, we have only been served the “appetizer". The real “feast" is on its way.

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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