Smoking guns may trigger US reversal

LAST WEEK, the US Federal Reserve shifted its policy stance in a way which substantially increases the risks facing the world's financial markets.

After a nine-month period in which the Fed has been basically leaning towards an easier or - at worst - neutral policy stance in order to promote the recovery in the world economy from the 1997/98 global financial shocks, they have now shifted to a "bias towards tightening".

This is not a watertight signal that higher interest rates are on the way - in the whole of Alan Greenspan's term, the Fed has adopted a tightening bias on 29 separate occasions, but has followed this with an actual increase in rates within 6 months only half the time. But on this occasion the warning signal should be taken seriously. Examining recent minutes of the Federal Open Market Committee, it seems unlikely that the signal would have been given unless there was a firm intention of tightening within a matter of a few months at most. So we are all now on notice that an important turning point in global monetary policy is probably at hand.

The remaining and crucial question is whether this is likely to be a gentle touch on the brakes, simply reversing part or all of last year's emergency easing in American monetary policy, or alternatively the sign of a savage monetary tightening which will kill the nine-year US economic expansion. The world's bond markets are already braced for the former event, so the financial markets could probably withstand a minor touch on the brakes. But neither bonds nor equities are remotely priced to anticipate the kind of savage rise in US rates, say of 3 per cent or thereabouts, which is normally needed at the end of an economic upswing.

What might trigger such a Draconian move by the Fed? Essentially, one of two events could do so - either a significant rise in domestic inflation expectations in the US, or an outright collapse in the dollar. If either of these (linked) events occurred, the Fed would have no choice but to tighten policy aggressively. This would, without question, reverse a significant part of the 1990s bull market in financial assets, and would quite likely turn into a hard landing for the US and world economy. The American economic miracle of recent years would then stand revealed as just another bubble created by the excesses of financial market exuberance which plague the world from time to time.

Fortunately, Alan Greenspan himself does not seem disposed to view the present situation in such a pessimistic light. In fact, he seems less concerned about "financial exuberance" than was the case a couple of years ago. In a fascinating speech in Chicago on 6 May, the Chairman gave one of his most detailed expositions to date on the role of technology in boosting labour productivity during the late 1990s, and therefore in prolonging the US economic expansion.

While agreeing that some part of the favourable surprises on US inflation have been due to "one-off" events such as lower oil prices and a rising dollar, the main thrust of Chairman Greenspan's remarks was to argue that technological advances had independently boosted the return on capital, that this had led to rapid growth in investment in high return projects, and that this in turn had boosted the capital/labour ratio in the economy, thus inducing a prolonged period of above-average growth in labour productivity.

In line with his normal cautious approach, the Chairman did not claim that the US economy was in a "new era" (and in fact correctly argued that technological change was probably greater at the beginning of the 20th century than it is now). But he did go so far as to argue that the economy was experiencing a "structural shift" which could have profound effects, overriding conventional economic patterns for a number of years. For a central banker, these are heady words indeed!

After establishing that a burst of independent or exogenous technical change has been the main factor behind the "remarkable" American economy of the 1990s, Chairman Greenspan then explained how the recent virtuous circle could come to an end. He pointed to three guns that would need to smoke in order to trigger a Draconian monetary tightening. Two of these related to domestic inflation, the third to the exchange rate.

First, the Chairman argued that no matter how fast productivity is rising, the demand for labour is rising even more rapidly. Therefore the pool of people potentially available for work (ie those recorded as unemployed, plus those not yet actively seeking work but who would like a job if they could get one) is falling by around one million per year. This has reached about 10 million (5.75 per cent of the population), which is the lowest such percentage on record. Unmistakably, this implies that the supply/demand balance in the US labour market is tightening. Sooner or later, the Chairman said, a continuation of this process would be bound to lead to rising wage pressures (despite the fact that the labour market has been behaving abnormally in recent years, as the graph shows). The laws of supply and demand, he observed, have not been repealed.

Second, there is a possibility that the rate of growth of productivity may itself begin to slow down. Here, the Chairman admitted that there is still an expectation in the business community that the process of productivity acceleration is continuing, but he simply added that "history advises caution". He made the point that forecasts of technological advance are notoriously unreliable, and said that the only certain thing was that when productivity eventually slows down, inflation pressures will assuredly rise.

Third, there is the danger emanating from the US trade deficit, which is showing every sign of exploding. The Chairman, however, described this concern as "distant", since he believes that the deficit can readily be financed for the time being, given the excess of savings which exists in Europe and Japan.

It is therefore clear that three particular areas - wage pressures, the rate of growth of productivity, and the behaviour of the US trade deficit and the dollar - need to be carefully monitored for signs that the Fed could suddenly turn aggressive. But the bulk of Mr Greenspan's recent remarks have veered surprisingly far in the direction of "new paradigm thinking", and have certainly not indicated that the Fed is on the threshold of a really major shift in its policy stance. If this interpretation is right, then the impending monetary tightening seems likely to be of the gentle variety which the bond markets are already anticipating.

There is, however, one way in which this could turn out to be much too optimistic. If either Europe or Japan were suddenly to resume growing strongly, the US would no longer benefit from strong disinflationary forces overseas. Furthermore, the foreign capital needed both to finance the American trade deficit, and to fuel the growth of US productivity, could suddenly dry up.

In these circumstances, all three of Mr Greenspan's guns could start to smoke simultaneously.

Paradoxically, therefore, the greatest threat to the American miracle would be a return to economic health in the rest of the world.