10/02/2012: Joining the hands of the US economy

US President Harry Truman once famously demanded a one-handed economist – exasperated by economists’ tendency to qualify all of their statements with “on the one hand” and “on the other hand.” The mixed signals emanating from the US economy right now also make it difficult to arrive at unequivocal conclusions: Recent statistics show a steadily improving economy, but the Federal Reserve continued to paint a sobering picture despite this new information.
First, let’s look at the statistics. While not outstanding, fourth-quarter GDP growth came in at a solid annualized rate of 2.8 percent. Moreover, the US labor market improved significantly in January, with unemployment dropping to 8.3 percent, the best figure since February 2009.
But compare this with Fed Chairman Ben Bernanke’s latest congressional testimony. After acknowledging improved economic conditions, he went on to stress that “the sluggish expansion has left the economy vulnerable to shocks,” and economic developments must be monitored closely because the outlook for the US “remains uncertain.” This is not exactly upbeat.
Reconciling these pictures presents us with another dilemma. We can claim that one is right and the other is wrong. Or we can consider the possibility that the Federal Reserve is motivated by more than the state of the US economy – and hence these perspectives are not so contradictory after all.
Many economists are taking the former approach, pointing out what they see as serious flaws in the data. The latest US growth figure may have been 2.8 percent, they say, but 2 percentage points came from involuntary inventory buildup. Real demand thus only grew by 0.8 percent, which is nothing exciting. Moreover, the GDP price index measured inflation at just 0.4 percent in the fourth quarter, taking nominal GDP growth to 3.2 percent. Correcting this growth for 3 percent headline consumer price inflation suddenly makes it look flat.
However, if we take the positive data at face value, I tend to think the Fed’s rather bleak comments have another goal. After all, if the economy really is improving, delaying the first interest rate increase until late 2014 simply doesn’t make sense – unless the Fed wants to see something more than a recovery before it hikes rates.
In my view, the Fed is waiting for a significant improvement of US public debt, which exceeds US GDP at over 15 trillion US dollars. The annual cost of servicing this debt will go up by 100 billion dollars with every rate hike of 0.65 percentage points .The US only enjoys even a AA+ credit rating is because its central bank can lower interest rates by printing money. If it were part of the Eurozone, where individual countries have no such recourse, its credit rating would likely fall somewhere between Belgium’s AA and Italy’s BBB+. Despite improving economic data, the Federal Reserve looks poised to keep rates lower until public debt comes down. By accentuating the negative at this potentially transitional moment – as the economic environment finally seems to be improving – the Fed can justify its decision without bringing US national debt into the discussion.