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The Fed's irrational economic exuberance

Marie-Josée Kravis

Is the U.S. Federal Reserve Board suffering from irrational exuberance? As measured as chairman Alan Greenspan’s testimony to Congress was last week, the semi-annual Monetary Policy Report he submitted presented rather optimistic economic projections for the remainder of 2001 and 2002. It seems that the members of the Board of Governors and the Federal Reserve Bank presidents—all of whom are part of the Federal Open Market Committee (FOMC—expect real GDP growth of 1 1/4% to 2% this year, and 3% to 3 1/4% in 2002. Given the sluggishness of the U.S. economy in the first two quarters of this year and expectations that the third quarter might be weak, this would suggest quite an acceleration of economic activity towards the end of 2001 and throughout the following year.

The Fed is confident that its aggressive easing of the stance of monetary policy in recent months, combined with tax rebates, anticipated reductions in tax rates and the recent weakening in energy costs, will fuel renewed growth. It does acknowledge that ‘the uncertainties surrounding the current economic situation are considerable, and until we see more concrete evidence that the adjustments of inventories and capital spending are well along, the risks would seem to remain mostly tilted toward weakness.’ Still, the hope is that the U.S. consumer, who accounts for two-thirds of U.S. GDP, will continue to spend until corporate confidence can be restored and investment spending can be resumed.

Consumer spending was up 3.1% in the first five months of this year, but just how long will U.S. consumers continue to but-tress demand? When will lay-offs, rising unemployment and softer labour markets begin to erode consumer sentiment? When will stock market losses and the reverse wealth effect force consumers to restrain household spending? Tax cuts will bolster household disposable income and consumer spending only modestly. What else will sustain consumer confidence?

Reports this week on the housing market shed a rather positive light on the status of household equity. Despite slower growth in home sales, the median price of an existing home rose at an annual rate of 8.9% from June, 2000, to June, 2001, the fastest rate in almost a decade. Strength in the housing market has caused a surge in mortgage refinancing as homeowners cash out on higher values. Economists estimate that with roughly US$495-billion in mortgage loans, refinancings have fed up roughly US$33-billion in cash. Economic analysts suggest that mortgage refinancing may have accounted for close to one-half of the first-quarter 1.2% U.S.-GDP growth. The risk is that the rate of growth of house sales has begun to decline, and slow sales will eventually mean softer prices and slower growth in home equity values. Add to this the fact that mortgage cash-out refinancings have been directed more towards spending than debt repayment, and it is clear that if this source of household income dissipates, the consumer will be unable to sustain the recent spending spree.

This shifts hope to further inventory liquidation and capital investment. Here is what Mr. Greenspan said on this very topic: ‘At some point, inventory liquidation will come to an end and its termination will spur production and incomes [Yet] despite evidence that expected long-term rates of return on the newer technologies remain, growth of investment in equipment and software has turned decidedly negative. Sharp increases in uncertainties about the short-term outlook have significantly foreshortened the time frame over which businesses are requiring new capital projects to pay off.’ Nothing new—a sharp turnaround is not imminent.

On the contrary, as third-quarter earnings estimates are revised downward and guidance for 2002 corrects the optimism which was based on earlier scenarios of a V-shaped recovery, a cloud of gloom could affect markets quite markedly. In addition, softness in foreign demand will perpetuate prudence and deter a rapid resurgence in capital investment. Clearly, Mr. Green-span had this in mind when he suggested that further Fed easing may be required this year. The front-loaded policy actions taken earlier this year, coupled with tax cuts, will begin to be felt more substantially towards the end of the year. But, as he acknowledged in his testimony, consumers and investors afflicted by a bout of pessimism may require much more reassurance, and in the words of Mr. Greenspan, ‘There is no tool to change human nature.’

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