economists worry whether the US Fed has already gone too
far with its rate hike campaign and the US economy may
face a recession by next year. If so how would US recession
affect global economy?
widely expected, the US Fed has kept the target Fed rate
unchanged at its meeting earlier this week. The Fed rate
currently stands at 5.25 per cent per annum, after a 2-year
long rate hike campaign, which started in June 2004 when
the rate was at a nearly 50-year low of 1 per cent.
Fed, under former chairman Greenspan, had reduced rates
consistently after the tech bubble burst to help the US
economy recover. As the growth momentum was regained,
the Fed started hiking rates in a series of ''measured''
steps of 25 basis points each. These rate hikes helped
keep inflation at manageable levels, if not below the
Fed''s own targets, when the US economy enjoyed a period
of good growth.
its new chairman Ben Bernanke, the Fed raised rates twice
earlier this year before deciding to pause this week.
Being new to the job Bernanke had to establish his inflation-fighting
credentials, which both his immediate predecessors
Greenspan and Paul Volker (yes, the same Volker whose
report was used by Natwar Singh''s detractors to put him
in the dock) - were famous for.
the decline in some of the major economic indicators over
the last few weeks have prompted many economists to worry
whether the Fed has already gone too far with its rate
hike campaign. They have also started worrying whether
the US economic growth would slow down considerably in
the coming quarters and, worse still, the possibility
of the US economy falling into a recession by next year.
the US slowdown going to be so bad?
What triggered fears of a US recession was a steep fall
in US GDP growth for the April-June 2006 quarter to 2.5
per cent per annum from as high as 5.6 per cent for the
Jan-March quarter. Growth was expected to decline during
the quarter, but not so dramatically.
fears were heightened on lower than expected job additions
and surveys showing a slowdown in the services sector.
Business spending has already lost momentum and consumer
spending has shown signs of following suit.
after all these adverse data, most economists still expect
the US economy to grow at around its long term average
rate of 3.5 per cent per annum for the full year 2006.
They reckon that even if growth remains subdued during
the third quarter, there would be a modest pick up in
the fourth quarter.
argue that the full effect of past rate hikes by the Fed
has not yet reflected on growth rates, something which
the Fed also acknowledges in its statement released this
week. While the Fed is taking this as a positive thing
for its moderating impact on inflation, some economists
worry that this pass through effect would pull down growth
rates in the coming quarters.
is generally accepted that it takes around a year for
the full impact of a rate hike to pass through. That is
why central banks all over the world are always worried
about being ''ahead of the curve'' or having the ability
to anticipate trends.
main driver of US economic growth over the last few years
has been rising property prices. Though real wages in
the US economy have remained near stagnant, consumer spending
remained robust as high asset prices lifted consumer spending.
Very low interest rates fuelled a home re-financing boom,
which left sufficient cash with consumers. Critics of
former Fed chief Greenspan have often blamed him for replacing
the ''tech bubble'' with a ''property bubble''.
the last year, property prices in the US have stagnated
and even declined in some areas. This has led to a considerable
fall in home re-financing, which is clearly affecting
real worry is that any further rise in interest rates
would see further declines in property prices, if not
a crash. Lower consumer confidence would affect spending,
especially since real wage growth is not expected to improve.
A slowdown in consumer spending is always the worst news
for the US economy, nearly 70 per cent of which relies
on domestic retail consumption.
pass-through effect of past rate hikes would make the
outlook more bleak, especially for the next year. Suddenly
the US economy, which looked reasonably robust till about
a month back, appears to be sliding downwards and appears
more vulnerable to external shocks.
prices can provide a shock
The biggest possible threat to US economic growth at present
is rising crude oil prices. Shutdown of the largest oil
production facility in Alaska has sent crude oil prices
to near record levels and oil at $80 per barrel seems
very close to reality.
the Middle East crisis worsens and the hurricane season
in the Gulf of Mexico is as bad as it was last year, oil
prices can rally much above $80 per barrel. That would
be a significant blow to consumer confidence as higher
energy costs would eat into disposable consumer income.
rating major Standard & Poor''s has forecast a bleak
scenario for the US economy if oil prices rise above $80
per barrel. If oil sustains above that level, the agency
expects US economic growth to slip to 2.5 per cent per
annum in 2007.
S&P forecast considers only the impact of higher oil
prices. The growth rates would be even worse if other
variables also turn adverse. The S&P report further
states that the US economy would be much more vulnerable
to other shocks as growth rate slows down.
inflation in the US ebb?
Consumer inflation in the US was at 4.3 per cent for June
and core inflation, after removing energy and food prices,
at 2.6 per cent is well above the Fed''s target range.
The fact that prices have not come down despite the decline
in growth rates during the second quarter has many economists
and analysts worried.
US Fed is clearly betting that the slowdown in economic
growth would cool inflationary pressures in the coming
quarters. But that is a very risky bet and one that can
easily go wrong. If US inflation does not ease in the
near future, the rate hike pause by the Fed would turn
out to be a case of inaction having a deeply distressing
last year, US inflation was held under check mainly through
productivity gains. But recent data indicates that such
gains are waning fast and a period of productivity decline
may possibly be near.
imports of goods and services, the latter through outsourcing,
have also helped control inflation in the past. This would
change if the US Dollar were to lose ground against other
currencies, making imports costlier. Most economists and
investors like Warren Buffet expect the ''dollar'' to lose
value because of the US current account imbalances.
are the risks, but it is also possible that US inflation
would decline in the near future as expected. Money supply
growth has already declined and real growth in money supply,
adjusted for inflation, may have already turned negative.
This may lead to a further cooling off in spending, both
by businesses and consumers, and keep inflation under
This is the worst-case scenario: US inflation continues
to rise despite a decline in economic growth rates. The
Fed is forced to raise interest rates further to fight
inflation and the US economy slips into a period of recession.
More skeptical economists and analysts have started worrying
about the probability of stagflation rising inflation
when economic growth is declining though it seems
unlikely at least for now.
such a scenario, the imbalances in the US external account
can either improve or worsen. If it worsens, we may face
a global financial crisis - the kind of which we have
not seen before.
in other parts of the globe would lead to lower demand
for US goods, especially heavy equipment. As export growth
declines, the trade deficit may worsen and exert further
pressure on the US dollar. A readjustment of imbalances
in such an environment can be very painful.
a slowdown in the US economy may also lead to lower imports
and in turn an improvement in the trade account deficit.
Slow growth in other parts of the globe may also lead
to higher investment flows into US assets, which are considered
the safest in times of uncertainty. Such flows would protect
the dollar from declining appreciably.
on global growth
Most forecasts, including those by IMF, expect the global
economy to sustain growth rates of over 4 per cent next
year as well. These forecasts are based on the expectation
that US economic growth would be closer to 3.5 per cent
the US economy slows down considerably, it would also
pull down global growth rates even without considering
the peripheral impact on other large economies. Other
central banks would also be influenced by any future Fed
decision to raise interest rates.
which rely considerably on exports to the US, would be
the worst hit. Japan may slip back into recession as demand
for autos, consumer electronic products and other equipment
declines. Most countries in South East Asia, which depend
heavily on exports, would also be equally affected.
impact on China would depend on how fast it can boost
domestic consumption to become the prime driver of its
economy. The Chinese government is making an all out effort
in this direction and the country may escape much damage.
if there is a sharp decline in global growth, the structural
imbalances within the Chinese economy may worsen the impact.
If investment flows into the country slowdown and the
known skeletons in its closet like the huge bad loans
of banks turns out to be even uglier, China would go through
some pain. If some unknown skeletons emerge in this turbulence,
deeper would be the pain.
would also face some difficulties, but would be better
off than most other large economies. Export growth would
decline and sectors like IT and BPO services which are
dependent on overseas markets would naturally be worse
off than others.
difficulties would worsen if oil prices remain well above
$80 per barrel. But the probability of India''s GDP growth
rates slipping much below 6-7 per cent per annum in the
medium term is low, unless the monsoons also fail.
none of this would happen and the global economy would
continue to maintain its current growth momentum for at
least another couple of years. But, undoubtedly, the risks
to such growth have gone up considerably in the last few