FYI | Jun 27 2006
By Greg Peel
National Australia Bank economists believe the Fed’s current inflation fears are well-founded, and a rate hike this week is all but a given. However, headwinds are gathering for the US economy for late 2006 and 2007. Another rate hike in August may well be anticipated, but could prove dangerous. NAB is not alone in its thinking.
"Tightening into a weaker economy has historically been unwise", says NAB chief economist, Alan Oster. NAB’s US GDP forecasts continue to be revised down, sitting currently at 2.75% for 2007 with downside risks. "And critically", says Oster, "those risks are domestically based".
The risk is that the Fed will put too much emphasis on the near term inflation outlook. While inflation is being fuelled by the secondary wave of oil costs, wages have not been driven up in response. If anything, they have fallen. As the economy slows, NAB believes inflation will retreat to the middle of the Fed’s range by late 2007.
NAB believes the Fed will tighten this week and again in August, taking rates to 5.50%. The economists then expect three rate cuts in the second half of 2007, back to 4.75%. Any more aggressive tightening in 2006 will only lead to more cuts in 2007.
DBS economists hold similar views to NAB. However, they are banking on only one more rise this year to 5.25% (although acknowledging the risk of another 25bps) and expect a cut as early as the first quarter 2007, with another in the second quarter, to bring rates back to the same 4.75%.
DBS sees stagflation ahead for the next two to three months. By the US autumn, slower economic growth will have set in. "The message is clear", says DBS, "while growth has been volatile in recent quarters, the trend continues to be downward".
US consumption will underline economic softness, says DBS – a point made also by NAB. Higher interest rates are already restrictive, higher oil prices are cutting into disposable income, weak housing prices have lowered equity withdrawals and there is now a longer term need to rebalance household balance sheets (ie save). Investment demand is derived from final demand (consumption, exports) so it too will begin grow more slowly in coming quarters.
DBS expects US GDP to run at 2.5 to 3.0% in the second half of 2006 and into 2007. The economists agree with NAB that wage pressures appear unusually low, and hence inflation fears should pass soon. However, the Fed may have already acted again in August.
Commerzbank expects the Fed will move to the sidelines after this week’s rise, calling a halt at 5.25%. Commerz sees US housing developments as the most crucial issue, although it believes a crash in housing prices is unlikely. Smaller increases in housing wealth and the Fed’s past tightening should combine to slow economic growth in the second half.
Commerz falls into line with the belief that inflation is a problem that will not go away quickly, but will go away nevertheless. There are no signs of a wage-price spiral, says Commerz.
"Only in 2007", says Commerz, "do we anticipate the Fed to ease monetary policy somewhat". The economists expect the policy stance after this month will be "roughly neutral" and that the probability of a recession appears relatively low. However, they suggest the US economy has already slowed considerably this quarter compared to last quarter.