US fiscal policy, exports weigh against December Fed hike

The Federal Reserve building in Washington, D.C.
Kevin Lamarque | Reuters
The Federal Reserve building in Washington, D.C.

This week, markets are expecting to see clear signs of the Fed's imminent interest rate increase.

That may well happen, but there is nothing in the Fed's current policy stance to suggest the preparation of such a move.

It would, therefore, be very unusual to see a sudden tightening of U.S. money market conditions under circumstances when neither the pace of economic activity nor the underlying inflation pressures call for a policy change of that nature.

Apart from that, the Fed is also facing a fundamental imbalance in the country's fiscal-monetary policy mix. The resulting one-handed approach to economic stabilization is reducing the effectiveness of extraordinarily easy credit conditions.

Market observers don't seem to realize that the Fed is working against a sharp and continued tightening of the fiscal policy which - at its current degree of restraint - is unable to stop the rise of America's huge public debt.

The Fed is also watching a powerful drag on the U.S. economic growth from deteriorating next exports caused by a weakening world economy and a surging dollar.

Offsetting tight fiscal policies

Think of it: Tight fiscal policies and a widening trade gap have a direct bearing on the Fed's ability to deliver growing jobs and incomes in an environment of price stability.

Take the fiscal policy first. At 4.5 percent of GDP, the U.S. budget deficit is the second-highest (after Japan) in the industrialized world; it is also twice as high as the euro area deficit. And in spite of a marked progress in fiscal consolidation over the last few years, America's gross public debt ($18.7 trillion at this writing on the Time Square's national debt clock) keeps climbing toward 111 percent of GDP.

This means that the Fed cannot count on any help from fiscal easing to stabilize the economy and to maintain employment growth. No, the fiscal restraint has to continue to keep the budget deficit on a declining trend in order to stop and reverse the growth of public debt.

There is no telling how long that will take. Just to stop the growth of public sector liabilities, the U.S. would have to begin running a primary budget surplus (that is surplus before debt service interest charges). At the moment, we have a primary budget deficit of 1 percent of GDP, and, on current policies, not much of a decline should be expected in the next few years.

The Fed, therefore, has to offset the ongoing fiscal tightening with low credit costs to keep the economy on a growth path consistent with steady income and employment advances.

By supporting growth, the Fed is also helping to reduce the deficit through rising public sector revenues. At the same time, the Fed's low credit costs make it possible to narrow the budget gap by holding down interest charges on public debt. These are currently at about 3 percent of GDP, but they are bound to increase with rising liabilities and widely anticipated higher interest rates.

Rising dollar is monetary tightening

The negative impact of the widening trade gap on growth and employment is an equally difficult issue. In the first three quarters of this year, for example, a combination of the weak global economy and a rising dollar has cut America's GDP growth by 0.6 percent; for this year as a whole that could knock off an entire percentage point.

Next year could be much worse. Rising insecurity and political instabilities are taking their toll on an already lackluster EU economy – a destination for one-fifth of American export sales. The euro is now down 15 percent year-over-year against the dollar. The ECB's widely expected additional easing will cause another round of the sliding euro.

Japan's monetary policy also remains hugely expansionary, and it will remain so for as far as the eye can see because Tokyo has no room for a meaningful fiscal easing to shore up its recessionary economy. The yen, as a result, has lost more than 4 percent of its value against the dollar over the last twelve months.

China, too, has joined the bandwagon of monetary easing and cheaper currency (the yuan is now down 4 percent with respect to the dollar from the year earlier) to support growth while it seeks to rev up household consumption and service industries.

The upshot is that in the first nine months of this year the U.S. trade deficit with these three large and slowing economies rose 8 percent from the year earlier and accounted for nearly 80 percent of our total trade gap.

So, here is the question: Since the appreciating exchange rate is technically equivalent to monetary tightening, is it necessary to raise U.S. interest rates (i.e., increase the dollar shortage) at the time of a rising dollar (i.e., rising excess demand for dollar assets)?

And here is the follow-up question: Is an imminent monetary tightening necessary because we are facing an overheating U.S. economy and gathering inflation pressures?

The answer to both questions is no. It is clearly wrong to raise interest rates while the greenback keeps rising, and while the weak economies and political instabilities in the rest of the world are likely to strengthen the demand for dollar-denominated assets.

There is also no evidence of an accelerating U.S. economy giving rise to underlying inflation pressures. Our economic growth in the first three quarters of this year (2.6 percent) is almost identical to the growth rate in the same period of last year (2.4 percent).

Similarly, over the same period, the growth of hourly compensations in the non-farm business sector was up 2.2 percent, compared to 2.7 percent in 2014. The growth of unit labor costs also slowed down to 1.6 percent from 1.8 percent last year.

And to top it all off, the U.S. consumer price inflation has been flat or negative in the first ten months of this year, compared with 1.5-2.0 percent inflation rates in the same period of 2014. Yes, most of our good inflation numbers is owed to tumbling oil prices, but that story is not over yet. Whatever competition they might be fighting, the Russians and the Saudis are still making money at $50/barrel, because their (onshore) marginal production costs are $18 and $3 per barrel respectively. Also, the Russians may be bombing to smithereens the Islamic State's black market for Iraqi and Syrian oil, but Iran is coming on stream.

Investment thoughts

I see no compelling domestic or international reasons for the Fed to rush into an imminent tightening of money market conditions in the United States. And, as of this writing, I see no indication that the Fed is moving in that direction.

Many people seem to believe that the Fed's rate hike is part of an impending market doom. Perversely, the doom sells. In some European countries, it is even fashionable. Some of these countries have built a prosperous financial industry by peddling doom and offering puny returns to their frightened customers.

I remain bullish on U.S. equities. Slowly growing labor costs in an expanding and amply liquid economy will continue to widen profit shares. America's world beating companies are some of the best and safest bets around.

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.