Home >opinion >US readying for stagflation

It was tempting to write about China’s phantom recovery. Bare Talk had not covered the Middle Kingdom in a while. But, that has to wait. There is still some unfinished work with that superpower on the Atlantic. I wrote about the cracks in the US economy last week. Within a short time, we got a concrete piece of data. On 23 August, the US reported monthly data on sale of new homes. New home sales in the month of July were down 13.4% (month-on-month). The consensus forecast of economists was for a drop of just 2%. After the fact, they cited that the recent run-up in the mortgage interest rates (from 3.4% at the turn of the year to 4.55% now) as the cause. Quite why they could not figure that out before the data was released is beyond us. Further, data for May and June was revised down substantially. The 8.3% increase for June was revised to a more sober 3.6% and the jump in May of around 2.1% was revised down to -1.6%. In fact, it is rather obvious in the data that the sale of new homes peaked in January of this year.

The broader stock market finished the day higher on Friday. As usual, the stock market investors are following its established pattern—what is bad news for the rest of the economy is good for them. The weaker the data, the less likely that the Federal Reserve will go through with its intent to reduce the monthly asset purchase—start date, speed of reduction, etc. This logic seems to be the driving force behind the gains in US stocks in the last two years and especially in the last 12 months.

The Federal Reserve Bank of San Francisco has recently come up with a good piece of research to show that asset purchases by the Federal Reserve have less impact on economic growth than a conventional cut in interest rates (Economic Letter, 12 August). Of course, the federal funds rate cannot be cut further. It is near zero per cent. Hence, the researchers at the San Francisco Fed recommend that the Federal Reserve guide the market to expect interest rate tightening much later than what the market currently believes. That, they reckon, is equivalent to a rate cut and is likely more effective (or, less ineffective) in boosting growth prospects than monthly bond purchase. Investors should take note.

The Federal Reserve is well aware, by now, that the medicine it administered for the economy was not effective at all. But, it worked in another area too well. That is, it boosted US stock indices to record highs. Hence, even if the Federal Reserve is comfortable withdrawing the medicine of asset purchases because it had no effect on economic growth, it must be worried that the stock market will react so badly that it would inflict significant damage on the already fragile economy.

Financial expert John Mauldin sums it up well: “Faith in central banks today is equivalent to faith in the word dot-com in 1999 or faith in the eternal rise of housing prices in 2006… The world no longer worries first and foremost about the products corporations make or the services they perform. Rather, it is focused on the amount of easy money the central banks can dish out." (Source: Thoughts From the Frontline, 17 August).

In fact, the last round of quantitative easing seems to have helped US financial institutions boost profits. Profits in the financial sector had declined to 7.1% of overall corporate profits in 2008 from a high of 35.5% in 2002. It has since rebounded to around 22.3% of overall profits in the first quarter of 2013.

At the same time, US workers are grinding it out. More than four years after the recovery began, part-time employment is rampant. Those who are employed part-time for economic reasons number 8.25 million. During the double-dip recession of 1980-82, as a proportion of the total employed, part-time employed was higher than at the peak in 2008-09 but the number was only 6.86 million. Importantly, it declined rapidly then as the recovery took hold, unlike now. Finally, real earnings have contracted in the last two years and look set for a hat-trick in 2013.

As hinted earlier, in all likelihood, the Federal Reserve will boost the forward guidance on accommodative monetary policy substantially even if it goes ahead with “tapering". The US dollar will weaken further against other developed currencies even if the US treasury market does not like the move. It would cause long-suppressed prices of commodities including that of crude oil to rebound. In any case, the world price of crude oil has held up rather well. Rise in US treasury yield and commodities prices could be a double-whammy for emerging economies. So, India should free up the prices of hydrocarbons and related chemicals completely and immediately. That would invalidate the obituaries being written for the Brazil-Russia-India-China, or BRIC, grouping.

V. Anantha Nageswaran is the co-founder of Aavishkaar Venture Fund and Takshashila Institution. Comments are welcome at baretalk@livemint.com. To read V. Anantha Nageswaran’s previous columns, go to www.livemint.com/baretalk

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