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America’s 'goldilocks' economy is here

US Currency
Source: Money Museum of the Federal Reserve Bank of Chicago

Reports of an apparently massive buildup of net long positions in the U.S. government debt instruments can reflect a number of different views of American economy. But don't let that bother you.

Here is a piece of evidence with a clear-cut meaning: Over the four quarters through April, the U.S. economy has grown at an average annual rate of 2.9 percent. That is more than an entire percentage point above its estimated growth potential – a pace of economic activity consistent with a non-inflationary rate of utilization of labor and capital resources.

That growth rate has made it possible to create jobs for nearly 3 million people, and to reduce the unemployment rate from 6.7 percent to 5.3 percent since the first quarter of last year.

Remarkably, these significant gains in output, demand and employment were obtained under conditions of perfect price stability. During the last twelve months, the U.S. consumer price inflation was driven down from 2.1 percent to 0.3 percent. True, most of that decline was due to the 23 percent drop in the price of energy, and to the dollar's trade-weighted appreciation of more than 20 percent. But that is not a flash in the pan; both of these rather exceptional events seem set to continue. There is an apparently growing excess supply of energy commodities, while the euro and the yen are undermined by extremely easy monetary policies and intractable structural difficulties.

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A strong dollar is a powerful influence on price stability because its exchange rate directly impacts activity and price formation in U.S. import and export sectors (about one-third of the economy) – and much beyond. For example, a 10 percent decline of our import prices over the last twelve months not only made cheaper foreign goods and services, but it also kept prices down in our import-competing industries.

Twin deficits remain a problem

The U.S. public finances have made a notable progress as well. Last year's budget deficit of 4 percent of GDP was down from its peak of 12.8 percent of GDP in 2009. But that did not stop the gross public debt from rising; at about 110 percent of GDP it remains a serious problem. To stop and reverse its climb, the budget before debt service charges would have to shift – rapidly – into a surplus position from its current deficit of 1.5 percent of GDP.

U.S. trade deficits are also a problem. This year, net exports could shave off an entire percentage point from the growth of our domestic demand – a direct consequence of America's steady and sustained output and a strong dollar.

So, to keep the "goldilocks" economy on track Washington would have to do quite a bit of work on improving America's public finances and external trade accounts.

The Fed's easy monetary policy can help offset a tighter fiscal stance, but there is not much that the Fed can do about trade deficits. That is an urgent task for the U.S. trade diplomacy. Washington would have to get Germany, China and Japan to realign their demand management policies in order to stop living off the U.S. economy.

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Germany is the worst offender. With a huge trade surplus of 8 percent of its GDP – a whopping $300 billion in 2014 (by far the largest in the world) – Germany clearly needs to generate more growth from its domestic demand.

Sadly, nothing of the kind is likely to happen. President Obama failed to get Germany off its disastrous austerity diktat to the recession-shattered euro area. He also failed to get Germany to help its euro partners with a stronger domestic demand. As it is, Germany's huge trade surpluses remain a fundamentally destabilizing economic force in Europe (nearly one-fifth of the world economy). And by sapping the area's growth and employment, Germany has also become a political and security issue for the West.

Get serious about trade imbalances

In any event, Washington is just fighting fires – as in the case of Greece's debt problems – but I don't see any coherent attempt to change directly, or through the IMF, Germany's dangerous policy misalignments. Meanwhile, Germany's trade surplus with the U.S. is currently running at an annual rate of $70 billion.

China is also a problem because the second-largest world economy should not be a drag on global growth. Beijing's current account surplus is on course to hit 3 percent of GDP in the months ahead. In the first four months of this year, China's trade surplus with the U.S. was running at an annual rate of $330 billion – a 13 percent increase from the same period of 2014. Like Germany, China would have to generate more growth from its domestic spending.

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Japan should be doing the same thing. But it is doing exactly the opposite. Thanks to its 22 percent devaluation of the yen against the dollar over the last twelve months, and its inability to grow domestic demand, Japan is back to its export-driven growth patterns. Tokyo is expected to generate this year a current account surplus of 3 percent of GDP – a huge jump from only 0.5 percent last year -- with most of the surplus coming from the U.S. trade.

Here it is: In the first half of this year, Japan's merchandise trade surplus with the U.S. soared 22.5 percent as its export sales in American markets rose 17 percent. By contrast, during the same period, Japan ran a huge trade deficit with China on an export growth of about 2 percent. It looks like Japan is dumping on the U.S. what it can no longer sell in China.

Investment thoughts

The Fed has led the U.S. economy to a steady and noninflationary growth path. Its further efforts would greatly benefit from a continued fiscal consolidation and from more balanced relations with America's largest trade partners. Structural policies to reduce (a) the number of long-term unemployed (2.1 million), (b) involuntary part-time workers (6.5 million) and (c) those who dropped out of the labor force because they could not find a job (1.9 million) would increase the U.S. growth potential and the effectiveness of the monetary policy.

But all that is a tall order.

The Fed knows that, and it also realizes that an economy advancing above its physical limits to growth no longer needs zero interest rates. Modest monetary base contractions since last April indicate Fed's cautious moves toward a more appropriate policy stance. The weak world economy, a deflationary impact of declining commodity prices and a continued excess demand for dollar assets will allow the Fed to pace its gradual exit from easy money without any undue haste.

America's "goldilocks" economy may not be such a fairy tale after all. But I would not follow the wise-guys in their net long jump on U.S. Treasurys. I am more comfortable with unbeatable U.S. equities, and I would also add some of that yellow stuff on any future dips.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.