Don't blame the Fed: The problem is America's tenuous grip on world order
- The Fed’s rate hike was a trigger to an explosive mix of rising budget and trade deficits, and an extraordinarily hostile domestic political scene.
- An unbalanced U.S. economy will continue to grow in the months ahead with the full support of an accommodative monetary policy.
- Attempts to weaken the presidential authority will compromise Washington’s ability to negotiate better trade deals, and to manage its increasingly difficult relationship with China and Russia — America’s main strategic competitors.
The Federal Reserve could have easily done without the latest interest rate hike. Resisting the White House's public appeal to keep rates unchanged was not necessary to show the Fed's independence.
The U.S. monetary authorities are now managing the most difficult phase of their policy process. Their attempts to prudently unwind a decade-long period of extraordinary credit expansion are triggering a wave of asset repricing dominated by market expectations that rising interest rates will lead to an economic slowdown of unknown amplitude and duration.
That is a situation deserving much greater attention than brushing off political intrusions with apparently capricious rate hikes causing losses worth trillions of dollar to American and worldwide savers.
The Fed may also wish to review the cacophony of its contradictory and confusing public statements about its real or implied policy intent. "Keep them guessing" as markets' betting fodder, and a form of dueling with Wall Street, is a game of another time. Regular disclosures of policy relevant data and decisions are enough.
Apart from those largely procedural issues, the Fed has done a good job in keeping afloat an economy beset by (a) deep structural problems in labor markets, (b) the depressive impact of systematic and excessive trade deficits, (c) excesses created by a long period of crisis management and (d) a totally unaffordable fiscal policy.
The Fed is doing a good job
Markets, of course, will join the administration's screams for more money on top of a huge $1.6 trillion liquidity in U.S. money markets. But markets will keep mum about the administration's failure to bring back into the active civilian labor force some of the 95.9 million Americans currently out of it, and they will see nothing wrong with the fact that, over the last two years, Washington could not stop America's soaring trade deficits with China, the European Union and Japan.
No, that is the hard part. It was much easier to push up public debt by cutting taxes. That had an immediate political payoff in the run-up to last November's midterm Congressional elections.
But expanding the labor supply would have raised America's potential and noninflationary growth from the dismal current rate of 1.6 percent. With that sort of physical limit to growth, a 2.8 percent pace of economic activity during the first three quarters of this year is a challenge to price stability.
So far, a strong inflation outbreak has been staved off by weak wages in an underemployed labor market, where the actual jobless rate last November was more than double the officially reported rate of 3.7 percent. That's the result you get when you take into account those 4.8 million people working part-time because they could not find a full-time job, and the 1.7 million persons dropping out of the labor force after 12 months of an unsuccessful job search.
There is the answer to analysts puzzling over a rather modest 2.6 percent increase in nominal hourly compensations during the first three quarters of this year, in spite of the lowest officially reported unemployment rate in nearly 50 years.
So, don't blame the Fed for unsettled financial markets. The Fed is a lone player in an economy accumulating huge debts and deficits while operating at nearly twice its noninflationary growth rate.
Don't destroy America's world order
At the moment, the U.S. public sector budget deficit is on the way to 5 percent of GDP, the public debt is running well over 108 percent of GDP, and this year's deficit on trades in goods and services with the rest of the world is currently estimated at more than half-a-trillion dollars, or about 3 percent of GDP.
And here is the upshot: Failure to stem America's decades-old rise of external deficits has led to a systematic borrowing of world savings to make ends meet. As a result, the country's net foreign debt position at the end of the second quarter of this year reached a record-high $8.6 trillion, marking an astounding $891 billion increase in net international liabilities from the previous three-month period.
That is the picture of a structurally unbalanced and a very vulnerable U.S. economy facing an unsettled political situation at home and growing security challenges abroad.
Predictably perhaps, foreign creditors are responding with a declining interest in American public debt instruments. During the 12 months to last October, non-resident holdings of U.S. Treasury securities fell by $124.5 billion.
Over that period, China and Japan, the largest investors in U.S. government bonds, trimmed their portfolios by a combined total of $128.8 billion, while running a $400.5 billion trade surplus with the U.S. in the first 10 months of this year.
A very intriguing gesture indeed: China and Japan not only declined to recycle back to the U.S. some of the dollar income from their large trade surpluses, but they also continued to actively sell their Treasury holdings.
There is a twofold message there. First, those sales could be seen as hedges against America's widely expected interest rate increases. Second, one can also see there a political subtext without falling into an exaggerated reading of unfriendly behavior.
Japan has been increasingly concerned about the forthcoming trade negotiations with the U.S., and could have been venting some of its displeasure by selling Treasury securities while pocketing a $56 billion surplus on its American goods trades.
China is a more complex case because Beijing's difficult trade negotiations with Washington are bound up with hostilities concerning China's maritime borders, arms sales to Taiwan, relations with Tibet and divergent views about peace and nuclear disarmament on the Korean Peninsula.
Investment thoughts
The Fed needlessly unsettled the markets with its defiant response to government's ill-judged comments on its pending interest rate decisions.
The U.S. economy will continue to grow in the months ahead, and the Fed will change little, if anything, to its present accommodative stance.
But the financial markets will be buffeted by (a) an unbalanced economy, (b) an extraordinarily hostile domestic political scene in the run-up to presidential elections in 2020, and (c) America's global economic and security challenges.
Attempts to weaken the presidential authority will sap Washington's ability to negotiate better trade deals with China, the European Union and Japan. That will also make it very difficult for the U.S. to manage an increasingly tenuous position with its main strategic competitors — China and Russia — and to hold together a fractured trans-Atlantic community.
The shorthand for those events are changes to the American world order. The U.S. unquestionably holds all the powerful cards, and it would be an unforgivable mistake to compromise that situation with partisan fights calling for impeachment and jailing of a sitting president.
Commentary by Michael Ivanovitch, an independent analyst focusing on world economy, geopolitics and investment strategy. He 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 Business School.