- Feb 02 2001 19:33:57 Confidence is all important. Facts and figures are subordinate. That belief seems to have taken hold in US financial markets: it may become a self-fulfilling prophecy. US government bond markets rallied at the end of last year on the expectation of interest rate cuts. The Russell 3000 index, a broad measure of US equities, rose 5.4 per cent in January; and the Nasdaq composite, comprising technology shares, jumped 18 per cent. But this confidence is only in the markets. It is not shared in corporate America or in US households. On Thursday, the National Association of Purchasing Management survey of US manufacturing fell to its lowest level in nearly 10 years. Tuesday's consumer confidence figures were at a four-year low. Economic figures and corporate results have been generally poor. Real gross domestic product in the fourth quarter grew at an annual rate of only 1.4 per cent, dragged down by a fall in private investment and consumers' expenditure on durable goods. The gap between market sentiment and economic figures rests, as so often in the past decade, on confidence in Alan Greenspan, chairman of the US Federal Reserve. The market's level reflects a consensus that the Fed can and will solve the current difficulties. The full percentage point cut in interest rates of the past month is only a start: with inflation low, there is no constraint on the Fed's power to ease monetary policy and get the economy motoring again. The market rally is therefore based on the logic that although the US downturn may be sharp, it will be short. Economic figures, even consumer and business confidence, are therefore retrospective indicators. Now the Fed is cutting rates, the prospects for the future are bright. A wide variety of arguments underpins market confidence in the power of policy to fine-tune American economic success. Confidence tricks First is the psychological effect of interest rate reductions. They are designed to boost the economy; households and companies believe in their effects; confidence is rapidly restored; and economic prospects brighten quickly. Second are the more traditional effects of looser monetary policy, which boosts spending relative to saving. Third is the powerful and rapid effect on corporate liquidity: lower rates ease cash flow worries. Fourth, gains in equity and bond valuations increase the net wealth of US households, which boosts expenditure. Fifth comes President George W. Bush's tax plan, which will raise consumer spending. And sixth, the rapid growth in US productivity, which will support economic growth and give the Fed scope to cut rates more aggressively than before. Under these circumstances, the recent equity rally would be justified. And if the Fed continues its "rapid and forceful response of monetary policy" to support growth, bond markets look, if anything, a little underpriced. Happy landing But this happy outcome misses a crucial point. Such a scenario would not be the "soft landing" the US needs. It would be no landing at all. As the latest research from Goldman Sachs highlights, "the private sector financial deficit in this forecast would remain at about 6 per cent of GDP over the next two years. Furthermore, the current account deficit would remain at close to 4.5 per cent of GDP." The unsustainable longer-term path of the US economy would continue. The dangers of a subsequent sustained period of low or negative economic growth would remain. An alternative interpretation of recent US events is that the private sector financial deficit is already unwinding. Falling consumer and business confidence, lower investment and durable goods purchases would therefore be an early indication of powerful contractionary forces. Looser monetary policy would not be able to mitigate these forces easily. Confidence and expenditure would continue to fall, earnings and equity valuations would suffer, tax cuts would arrive too late to help and the traditional and powerful effects of rapid monetary policy easing would take their time, as they always have in the past. The bright spot in this gloomy scenario would be government bonds. Goldman Sachs forecasts that interest rates would rapidly fall to 3 per cent, a much steeper fall than the forward markets expect, significantly boosting the price of US Treasuries. The confidence in equity markets is based on two premises. First that economic policy can sort out current economic difficulties. That may be true. Second, that once the US economy recovers, it can continue growing indefinitely, as it has in the past decade. That is not true. Short-term success in averting a recession is most likely to be achieved at the expense of long-term imbalances that cannot be sustained. ) Copyright The Financial Times Limited 2001. _______________________________________________ Crashlist website: http://website.lineone.net/~resource_base
