Mixed Signals Are Dividing the Experts

Ben Bernanke thinks America’s economy is strong, and that inflation remains a danger. The stock market believes the Federal Reserve Board chairman, so share prices hover at record levels. The bond market doesn’t — it expects that he will soon have to recognise the economy’s underlying weakness by lowering interest rates, not this week when the monetary policy committee meets, but almost certainly by the spring. The currency market is siding with the bond market, its players guessing that the Fed will indeed have to cut interest rates, making the dollar less attractive relative to the euro and sterling.

So the dollar is weak, which should add to inflationary pressures by making imported goods dearer and giving domestic manufacturers room to raise prices, thereby forcing Bernanke to raise interest rates even if the economy is slowing. We used to call that stagflation.

Confused? With good reason. So is the Fed, and so are the markets. But be kind — the situation is characterised by cross currents that are difficult for even the most experienced economist to navigate. Let’s start with housing. Everyone agrees that the bubble — if it was a bubble — has burst. Or, to use former Fed chairman Alan Greenspan’s formulation, that the froth has come off the brew of speculation. If you prefer Bernanke’s phrase, we are witnessing a “correction”.

A slowdown by any other name means the same thing. Sales are down; inventories of unsold homes are up by 50% over the average in the past decade even though construction of single-family homes is down 35% since its peak earlier this year; and prices have softened. So far, so agreed. But the impact of this development is unclear. Some think the slowdown will frighten consumers into reining in spending, especially as they can no longer borrow repeatedly against the rising value of their homes. Others argue that rising share prices are repairing consumers’ balance sheets, that there is no sign the service-sector boom will taper off, and that the growth in real wages will buoy spending, especially as Christmas cheer begins to perk up consumers.

The difference results in widely varying forecasts — a 2007 recession by pessimists who think the housing problems will wash over the general economy, growth in the 2% range by those who expect a ripple from housing rather than a wave, 3% growth by what we might call the economy’s cheerleaders. The latter point to the fact that slowing residential construction is being accompanied by a mini-boom in the construction of offices and factories: non-residential construction in the last quarter jumped 27% over year-earlier levels, the greatest gain in more than a quarter of a century.

The housing sector’s effect on the economy is not the only unknown. As the American economy slows, many economists are relaxed, believing that Europe will take up the slack. Consumers in Germany are more optimistic than they have been for five years, and the European Central Bank is so certain that the eurozone is headed for decent growth that it is planning to continue raising interest rates lest inflation get out of hand. Inbound investment is growing in response to high returns on equity, and labour markets are improving.

But this recent past will not be prologue if the American slowdown hits the eurozone hard. Optimists say that the EU is far less dependent on America than it once was. The tourist trade has diversified so that growing numbers of bewildered Japanese and, increasingly, Chinese tourists can be seen plodding through the churches and palaces of Europe, following signs only recently translated into their languages. And don’t try to muscle the army of Japanese tourists away from the Hermè s counter in Paris: the response may not be a courteous bow.

Euroland is also less dependent on the American market than it once was. Only 8% of the exports of the EU 25 now go there, so a fall in consumer demand in America should not hit Europe’s economy too hard.

Unfortunately for the EU optimists, that is only part of the story. Many European companies now serve the American market through subsidiaries located in the US, so their sales (five times EU exports, according to the Financial Times) do not go into the export totals. But if they are hit by falling demand, their repatriated profits will decline, eventually affecting demand in Europe. Indeed, if the American market were of little importance to Europe’s exporters, French authorities would not be as disturbed as they are by the decline in the dollar that is making European products more expensive in America.

So the conclusion must be that we just don’t know how much of a boost the American economy can expect to get from accelerated growth in Europe, even if that is sustained at the current 2.5%-2.9% rate next year, which the European Central Bank deems unlikely.

It will, therefore, be several months before we find out whether Bernanke’s cheerfulness about the economic outlook is well founded, or whether he will have to do what the Fed did almost exactly five years ago. At the end of 2001 it professed great concern about inflationary pressures, just as Bernanke has done at the end of 2006. Two months later it cut interest rates, the first of 13 reductions.

Perhaps it is best to keep in mind the observation of Donald Kohn, Fed vice-chairman, that: “Policymakers always face an uncertain economic environment . . . We are uncertain about where the economy has been, where it is now, and where it is going.” If, after 36 years with the Fed, Kohn suffers from uncertainty, we should be permitted to share that condition.

This article originally appeared in the Sunday Times. (London)