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Economic Perspective
Prepared by Merrill Lynch & Co.
Global Securities Research & Economics Group
Household Demand Growth Surged In The Third Quarter
Household demand grew in excess of five percent in the third quarter, a pace that can not likely be sustained. Had it not been for a sharp deterioration in net exports, growth in the third quarter would have been significantly higher. This prompted wide-spread expectations that the Fed would raise rates to slow growth and to counter a labor market which was tightening to the point that would increase wage and possibly price pressures.
The situation may be changing quickly. Retail sales have fallen the past two months, and there is little evidence of price increases being passed on to the consumer. Growth in household demand is likely to be just two percent or lower in the fourth quarter, and GDP growth is expected to slow to just above two percent. The most recent weekly jobless claims rose rather sharply to 333,000 from their recent base just above 300,000. Further, anecdotal data on weekly retail sales suggest the slowdown is continuing as the holiday season is approaching.
The news does not all point to a slowdown. The stock market has regained a portion of its recent losses and has stopped reacting negatively to the almost daily developments in Asia. Further, refinancing of mortgages is increasing as longer-term rates decline. This tends to put more money into the hands of the consumer and periods of increased refinancing are correlated with stronger spending growth.
Labor Market Still Look Tight
The cutting edge question, then, is whether the slowdown in growth will be sustained long enough and will be deep enough to relieve pressure on the labor market. We think that the answer will not come soon and that the labor market will remain tight, prompting the Fed to retain its bias to tighten. Indeed, were it not for the developing Asian problems we think the Fed would have tightened at its November meeting.
While we expect the labor market to remain tight, we also think that the Asian problems will have an intermediate term impact which tends to slow U.S. growth. The first evidence will be the strength of holiday sales and on that score we think sales will be good, but not as great as had been expected just a couple months ago. Thus, analysts will argue over whether the level is good or bad for, say, the bond market. As long as the financial crisis in Asia is developing and being addressed, this argument will stay in the background as a factor influencing interest rates.
Another question of importance impacting the interest rates and equity markets will be whether the tightening labor markets will result in inflation, a profit squeeze or both. We tend to be in the camp expecting a bit of both. If U.S. domestic demand remains solid, then industries which are protected from foreign competition such as domestic airlines and many services will be able to raise prices somewhat and thus pass along wage increases to their customers. Goods industries that are faced with stiff competition such as the auto industry will not have much pricing power. While productivity gains may remain strong, we doubt that the rate will rise from the current robust year-over-year level of 2.5% and we would not be surprised if the third quarter 4.3% rise was the “high-water mark” for many quarters to come.
Fed Still On Hold
On balance, then, the Fed is likely to remain on hold, refraining from easing because of a healthy economy and potential for some upward price pressures, but also refraining from tightening because of some economic slowing, the precariousness of the Asian financial system, and because a squeeze in profit margins may well act as a brake on the stock market and thus indirectly on consumer spending.
Japan Needs To Stimulate Domestic Demand
Turning to the world economy, there to we see a slowing but with a potentially more ominous implication. While Japan appears, finally, to be addressing its need to recapitalize its banking system, it has, to date, not indicated how it will stimulate domestic demand. Certainly the liquidity which the injections into the banking system will provide is a positive which will provide the “grease” for economic activity. However, with rates already quite low, we think Japanese officials will have to provide a trigger for stimulating demand as well as providing liquidity. Indeed, Japan appears to be the first major example of a country suffering from a Keynesian “liquidity trap” since the end of World War II.
While their situation is not anywhere near as dire, Europe is trying to consolidate fiscally and the “lynchpin” Bundesbank which has increasing power in that the monetary policies of many more countries are directly tied to its policy moves, is tightening. Both the U.S. and Canada have shown the virtue of an easy money policy to counteract the retarding effects of fiscal consolidation. We have been a critic of the recent Bundesbank rate rise, and wonder why they have not learned the obvious lesson of coordinating fiscal and monetary policy in a way that enables growth to boost tax revenues and reinforce the consolidation process as opposed to offsetting the attempt to reign in spending by sacrificing tax revenues by keeping people out of work. Unemployment is 11.2% percent in Germany, 12.5% in France, 11.7% in Italy, and 20.9% in Spain. Only the UK has put its population back to work by moving away (in 1992) from “enslaving” its monetary policy to the altar of a Bundesbank which is too fearful of inflation and not knowledgeable enough about economics.
Little Scope For Use Of Interest Rates To Stimulate Growth
Given the floundering in Japan and what we feel are misguided policies by the Bundesbank, any slowdown in U.S. growth would leave global growth well below the OECD and most private analyst forecasts in 1998. Further, if a world recession did develop, there would be little scope for using interest rate reductions to stimulate demand since rates are already much lower than they were several years ago. Global leaders would then have to reverse their fiscal consolidation and once again take on debt to finance recoveries. These leaders have done an excellent job of curbing inflation, but may now face a bigger challenge of keeping a labor force with rising expectations employed.
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
November 26, 1997David Horner
Merrill Lynch & Co.
Global Securities Research & Economics Group
North Tower, 21st Floor
World Financial Center, New York, New York
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