EYE ON
AMERICA Inflation less painful than
recession By Peter Morici
For the past month, the interest rate on
10-year US Treasury bonds has dipped about a half
a percentage point below the yield on a
three-month Treasury note. In a solidly growing
economy, investors expect to receive higher
interest rates, or yields, when they tie up money
for longer periods, and the inverted yield curve
we now observe is causing speculation that a
recession is imminent in the United States.
Don't bulk up your stock portfolio with
recession-proof investments
like
utilities. This time more inflation is as likely
as a recession.
Historically, long rates
dip before recessions because investors expect
growth to slow and short-term interest rates to
decline within a few months. However, over the
past six years, four factors have disrupted
relationships between long and short rates, and
old rules may no longer apply.
First, in
2000, US stocks had become hugely overvalued
thanks to the high-tech frenzy and accounting
improprieties. The market bust drove investors to
safer places, including long-term bonds. That bid
up bond prices and lowered yields, even as a
booming housing market soaked up massive amounts
of long-term financing.
Second, China's
and other Asian central banks have been soaking up
Treasury securities to keep their currency values
low against the US dollar, exports cheap, and
domestic economies booming. Those purchases are
not yield-sensitive, and their massive size pushes
down long-term bond rates.
In June 2004,
the US Federal Reserve began raising the Federal
Funds Rate. Since then, by purchasing US
short-term securities, the Fed has added only
about US$78 billion to currency in circulation and
bank reserves that back up loans. That is not much
in a $13 trillion economy, and the prime rate on
short-term business loans has risen from 4% to
8.25%. Meanwhile, foreign central banks have
purchased more than $750 billion in US securities,
and the rate on 30-year conventional mortgages is
hardly changed at 6.2%.
Third, an aging
population has a preference for more bonds and
fixed-income securities. The oldest baby-boomers
are now 62. No one should be surprised that the
demand for long bonds is up and yields are down.
Fourth, in recent years, the Federal
Reserve has established greater credibility as an
inflation fighter, and this has caused many
investors to assume long bonds are less risky than
in the past.
All this is good and bad for
the US economy.
The good news is that the
housing market will continue to be supported by
Chinese and private investor purchases of Treasury
and other fixed-income securities. The housing
bubble warrants a correction in land values but,
as long as long bond rates stay low, the
correction will be mild. Prices on existing homes
won't fall a great deal. Prices may stay flat for
several years but homeowners, unlike during the
bust of the early 1990s, will be able to sell
their properties.
The bad news is that
Chinese and other foreign government intervention
in currency and bond markets has dramatically
reduced the effectiveness of Fed policy. Central
banks in China, South Korea and other Asian
countries now have as much to say about US
monetary policy as the Federal Reserve.
This comes at a time when prices for key
commodities such as crude oil and iron ore are
determined by hyper-growth in China and elsewhere
in Asia. Those forces are driving up gasoline and
other material prices. This has gradually pushed
up inflation for other products, too.
Also, US labor markets are tight because
competition from Asian imports, advantaged by
undervalued currencies, are pushing workers out of
manufacturing and into services, but those workers
lack skills for hard-to-fill vacancies in finance,
computer services and other booming service
sectors.
Consequently, getting inflation
below 2%, as Fed chairman Ben Bernanke would
prefer, would require draconian tightening of
short-term interest rates by the Federal Reserve.
That would cause a long recession and painful
recovery, with real incomes falling for several
years.
In the end, the Federal Reserve is
as likely to leave interest rates unchanged for
the balance of the year, accept more inflation,
and skirt a recession.
Peter
Morici is a professor at the University of
Maryland School of Business and former chief
economist at the US International Trade
Commission.
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