What the US economy really needs next
- 31 August 2015
- From the section Business
When Chinese stocks took a nosedive last week, it rang economic alarm bells around the world, including in the US. But the threat to Americans' prosperity is less than you might think, says Chris Low, chief economist at broker dealer, FTN Financial, in New York.
The dreaded R-word, recession, has popped up on financial blogs and magazine headlines. Bloomberg BusinessWeek asked if the next recession will be made in China, while The Economist documented 'The Great Fall of China'.
The stock market is a pretty reliable economic barometer, after all. People thought it must be tanking for a reason. But the rally in stocks Wednesday and Thursday, followed by Friday's gentle drift sideways, offers an opportunity to take a deep breath and reassess.
The sell-off was caused by fears about both China and the US central bank, the Federal Reserve, but the actual threats to the US economy posed by China and the Fed are less well understood. Indeed, it is this very uncertainty that is at the heart of the market's volatility.
The US economy is in surprisingly good shape. Yes, last year's oil price drop and dollar strength dealt a body blow to corporate earnings, which in turn caused capital spending to dry up for a couple of quarters. But recent data shows a recovery is already underway. Corporate profits rose in the second quarter and business investment is on the up.
Consumer spending growth picked up to more than 3% in the second quarter, more than twice the first quarter's pace.
The latest gross domestic product (GDP) figures show an annualised growth rate of 3.7%, almost twice the 2.25% average since the financial panic of 2008-09. That is downright respectable. Inflation is low and will probably remain low for years, thanks in part to recent big declines in commodity prices - especially oil.
But what about those looming risks? What does slower growth in China mean for the US? And what about Fed rate hikes, which could begin as soon as three weeks from now?
Bear in a China Shop
China is 13% of the global economy. It has a voracious appetite for raw materials far out of proportion with its size. In 2014, for instance, China imported almost two-thirds of the world's iron production. According to a chart made famous when tweeted by Bill Gates last year, China used more concrete in the last three years than the US used in the entire twentieth century.
This year, China's commodity imports have plunged, dragging global trade down 5% so far this year, a big enough drop that people are starting to wonder if peak globalisation is behind us.
Some of these raw materials went toward manufacturing, but most were poured into a 20-year construction boom that peaked years ago. And while that's bad news for commodity producing countries - Russia, Brazil and probably Canada and Australia are in recession - it is not necessarily bad news for the US, which has an extraordinarily diversified economy.
Sure, some individual companies, like Boeing, GM and Caterpillar, will suffer. And forget about the little oil companies that were getting rich off fracking until last year. They are done.
But consumers, who account for two-thirds of US GDP, will benefit from lower prices. Airlines are already enjoying fatter profit margins thanks to much lower fuel prices and home builders will benefit from lower input costs as copper, lumber, concrete and steel prices fall. Households will reap savings from these later, when economic competition pushes marginal profit gains through in the form of lower prices.
On balance, then, lower commodity prices, the consequence most obvious to Americans of China's slump, are a plus for US growth.
Rate hike suspense
Which brings us to the Federal Reserve. Despite a whole lot of sometimes confusing rhetoric (Fed chair Janet Yellen famously told reporters she watches 25 different employment measures), what really matters is the unemployment rate, which is already signalling the need for rate hikes.
The Fed sees full employment as between 5% and 5.25%. In July it stood at 5.3%, awfully close to that range.
In fact, given their belief that it will take two-and-a-half years to normalise interest rates and that monetary policy takes 18 months to work, it's a wonder they have not raised rates already.
Fed officials were gathered at the annual Kansas City Fed Jackson Hole Symposium last week, and several gave interviews.
Three of them - Esther George, James Bullard and Loretta Mester - have been outspoken in their support for rate hikes since late last year, so it was no surprise they spoke up in support of a September hike again last week. The pithiest comment from the three came from Bullard, who said Fed officials are often reluctant to tighten in the midst of the kind of turmoil we saw last week; but then there was no Fed meeting last week.
Vice chairman Stan Fischer offered observations so carefully balanced they added nothing to people's understanding of the Fed.
That left Bill Dudley, the New York Fed president, as the standout in terms of clarifying the Fed's thinking. He said that financial markets and the world economy will affect the Federal Open Market Committee's decision on rates, but only in as much as these things are likely to affect the US economy.
And because the Fed characterises all of the effects of global and financial turmoil as "transitory", as in transitory low oil prices, US dollar strength and emerging market weakness, there's little doubt Dudley thinks a rate increase is the right move for the US.
Outside the Fed, others are not so sure. Former Treasury secretary Larry Summers, who was the frontrunner for Janet Yellen's job until he withdrew himself from the running, says the Fed should engage in another round of quantitative easing (QE), or stimulating the economy by pumping money into it, rather than raising rates.
Ray Dalio, the boss at Bridgewater, the world's biggest hedge fund, agrees with Mr Summers. In fact, last week he told financial news network CNBC that the Fed may raise rates a couple of times, but its next big move will be to introduce another round of QE. He says it is the only defence against global deflation, now that the Fed and other central banks have taken interest rates to zero.
But remember, the Fed doesn't believe US inflation rates are determined by anything other than the US unemployment rate (and consumer inflation expectations, but these never seem to change). The strong dollar, collapsing global trade, emerging market recession and low commodity prices are all "transitory."
As a result, that means even if Dalio and Summers are right about what the US really needs next, the Fed is likely to start raising interest rates in three weeks time. Unless, of course, we find ourselves in the midst of another bout of financial markets panic, in which case they will wait until October.
Meanwhile, it is worth remembering the Fed has history on its side. The financial markets almost always panic before the first rate increase, but also almost always calm down once investors see proof that the economy can handle higher rates.
There is no reason it should be different this time, at least until 2016. And if the Fed really does take an extraordinarily gradual approach, as has been promised, it should be able to adjust its tactics to avoid slowing growth into recession.