Greenspan Sees Manifold Dangers Lurking Around The Corner

Wednesday, July 20, 2005

Cartoon Alan Greenspan used his 3-hour testimonial to Congress to reiterate his already often cited concerns about the future of the economy. Demographics, the education system, the low savings rate, federal spending and the resulting deficits topped the negative list of his topics in the Q&A session. He showed himself pleased with the upturn of federal revenues but cautioned that it is too soon to know where these are coming from. The semiannual Monetary Policy Report (MPR) (PDF-version with lots of charts here) which he presented to Congress contains a key forecast of incrementally lower real GDP growth in 2006 of 3.25 to 3.50 percent while the Fed expects this year's growth rate to come in at 3.50 percent. "Core" inflation is seen contained between 1.75 and 2 percent. The unemployment rate is expected to continue with a 5 before the comma.
Oh, and don't forget to bet the house on more rate hikes to come. His introducing remarks ended with the well known phrase "...believes that policy accommodation can be removed at a pace that is likely to be measured."
Having read both the MPR and his remarks as well as listened to the Q&A session The Prudent Investor notes a telltale of cautioning. The inflation outlook sounds as if the Fed no longer believes in a significant reversal of crude oil prices. If worse comes to worst, "a further rise could cut materially into private spending and thus damp the rate of economic expansion," Greenspan said. He later softened this remark and added that consumers will switch to more fuel-efficient cars but he does not see much flexibility in the mileage driven.
195 days before his scheduled retirement Greenspan still spends sleepless nights over the rate conundrum. In his words the Fed has not yet come to a conclusion whether the low yields on the long end are a result of lower inflation expectations or high savings rates around the globe (with the exception of the US).
Inadequate Savings Rate
He considered the domestic savings rate "inadequate" in the light of the assumption that borrowing from abroad at current volumes cannot go on forever. Nevertheless the financial system is very efficient in transforming the minuscule savings rate into capital investments, he said.
In this context he pointed out that the savings rate and people's complacency with it depends on subjective factors. People realizing capital gains - currently in the property market - would feel as if they were saving because their purchasing power has been rising. But he warned of structural problems since capital gains were not fuelling investment as only book-value savings would do that.

Mortgage Rates Since 1990

GRAPH: There is a clear reason why consumers poured everything into real estate since 2002.
The Fed head warned about the gaining popularity of interest-only mortgages and exotic adjustable rate mortgages, which seem to have led to an "apparent froth" in housing markets and could leave borrowers "vulnerable to adverse events." He said it was not the Fed's task to curtail lending but only to oversee whether banks were lending on a sound basis. Stable delinquency rates in the MPR show this is still the case. But banks have loosened their lending standards to medium and large size borrowers significantly since 2000, the MPR shows too.
Company Profits Not Used For Investments
On the corporate side the MPR noted that profits were still on an upward pace but that the money was rather used for stock buybacks instead of capital expenditures. "Given continued strong corporate profits and the accompanying strength in cash flow, nonfinancial firms'
demand for external financing to fund capital expenditures has remained somewhat subdued. Net equity issuance has stayed negative so far this year, and share retirements have been boosted by considerable stock buybacks and cash-financed merger and acquisition activity. Gross corporate bond issuance has been limited, and the proceeds have been used mainly to pay down existing debt."
Greenspan also warned against protectionist moves against China and called globalization a process of creative destruction. But it would be in China's interest to flexibilize the exchange rate in order to more effectively neutralize the huge capital inflows it has been experiencing.
Representatives asked Greenspan also about the economic effect of the "war on terror." He said that resources for protection cannot also be used to increase production and productivity. The public portion of GDP has climbed to 38 percent recently. Not exactly a level one would associate with a free market economy. Compare this with "socialist infested" India where the government portion lies at 12 percent.
CONCLUSION: All seems more or less OK for the moment but manifold dangers have been lurking around the corner for some time now without one of them being effectively addressed by the administration. Greenspan will be a happy man to retire before all the known problems will begin to exert negative effects on the economic situation.
The maestro did again a good job at keeping markets in equilibrium. Tomorrow's testimony to the Senate will probably bring a repetition of today's key points. The release of the FOMC minutes later in the day can be ticked off as well because all key statements about the state of the economy are already included in the MPR.
But don't idle away because of this outlook: Fed governor Donald Kohn is scheduled to give a speech at the Financial Market Risk Premiums Conference that will focus on market imbalances. Remembering his exceptionally tough remarks from last month, reported here, this could become the main market mover for Thursday.
NOTE: Second post on his remarks about gold coming.

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