Marc Chandler

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Global Briefing: Marching Out of Step

Marc Chandler

The key issue in the global capital markets is the prospect of a synchronized growth cycle that will lead major industrialized countries to raise interest rates in the coming months. While the world economic outlook has improved in recent months, the recoveries in Europe and Japan appear too fragile at this juncture to tolerate a tightening of monetary conditions.

If there were a debate over the outlook for U.S. monetary policy, the stronger-than-expected July jobs data, released on Friday, resolved it. A tightening by the Federal Reserve at the Aug. 24 meeting is as close to a done deal as these things ever get. In addition, the risks have increased of another 25 basis-point hike at the Oct. 5 meeting.

Milton Friedman, the patron saint of monetarism, argued that inflation is once and always a monetary phenomenon. While it sounds nice, in reality inflation is just as much a psychological phenomenon. Fed tightening is meant not to combat current inflation, which according to most measures of general price levels like the GDP price deflator and personal consumption deflators is quite benign. The Fed, should it move, will be targeting investors' inflation expectations.

The markets' inflation expectations are being fueled largely by the persistent strength of the U.S. economy. With the global financial crisis subsiding, the extraordinary easing by the Federal Reserve at the end of last year is thought to be no longer necessary. Indeed, that accommodation is now seen as a possible threat to the largely well-balanced economy.

The next batch of important U.S. economic releases will likely show inflation fears are still in the realm of psychology and not in the material world. Specifically, after excluding the volatile food and energy prices, both the July producer price index and the consumer price index are likely to have risen an inconsequential 0.1%.

Third-quarter growth is likely to surpass the second quarter's 2.3% as businesses build inventories in anticipation of increased demand ahead of Year 2000 bug. This implies consumption should not be expected to be the driving force. Household consumption slowed in the second quarter and July retail sales data due out on Aug. 12 are likely to point to a continuation of that trend. Retail sales account for roughly 40% of household consumption. Look for a 0.1% to 0.3% rise. Further ahead, many businesses appear to be planning for a marked slowdown in the fourth quarter.

Growth prospects in Europe are improving, but thus far it is largely limited to sentiment indicators and exports. Unemployment remains stubbornly high and domestic demand remains soft. Italy, the third-largest economy in the eurozone, is still struggling, while the recovery appears to be taking hold more fully in Germany and France.

The U.K. releases several important reports over the coming days, including producer and retail prices, retail sales and employment. On balance, it appears the U.K. economy is also recovering, but the key inflation gauge, retail prices excluding mortgage payments, is likely to still be below the government target of 2.5%. Fears of a near-term tightening move by the Bank of England are exaggerated.

The Japanese economy is also too fragile to tolerate a tightening of either fiscal or monetary policy. Japan's government is still debating whether its 0.5% GDP forecast is achievable without additional government spending. A consensus appears to be forming for a supplemental budget of 8 trillion to 10 trillion yen, which will likely be unveiled ahead of the Group of Seven meeting in late September. There is still evidence of deflationary forces at work in Japan, which will compel the Bank of Japan to continue keeping short-term interest rates close to zero.

Most currency economists at the leading investment houses have been dead wrong about the dollar. They started the year expecting the dollar to be weak. They reversed themselves in the spring and by early summer were coming up with all kinds of long-term structural explanations for the dollar's strength. Just as a consensus was being formed for the euro to fall through parity, the pan-continental currency staged a sharp recovery. As the investment-house economists turned bearish and again cited structural reasons, the dollar is poised to correct higher. Look for the euro to slip back toward the $1.0550 to $1.0600 area after probing above $1.08 in the first week in August.

There simply is no evidence that foreigners are repatriating money. It is true the data show foreign investors becoming net sellers of U.S. Treasuries, but their purchases of corporate bonds, stocks and direct investment more than compensate. U.S. bonds and stocks continue to outperform their European counterparts. Similarly, the Japanese stock market has been trending lower since the middle of July, which corresponds to the dollar falling below the 120 yen level and not looking back. The idea that foreigners are driving up the yen to buy Japanese stock falls short of explaining the price action past month.

Press reports of a dollar crisis are grossly exaggerated. The dollar's recent low near 113.65 yen corresponds to the level that the greenback began the year. There has been volatility to be sure, but net-net, the dollar is unchanged against the yen this year. And of course, the dollar remains much higher against the euro than it began the year.