The US Economy: Is Manufacturing and the Yield Curve Signalling Recession?
The US yield curve is giving a lot of economic commentators the jitters. The rule is that whenever the yield curve goes negative, i.e., short-term interest rates exceed long-term interest rates, a recession emerges some 12 to 18 months later. There was a great deal of hand-wringing in late 2005 when the yield turned negative. Recently the curve has started to flatten, with some commentators now predicting that it will once again go positive and give the US economy another spurt of growth.
The odd thing here is that the economic commentariat do not seem to realize that in a truly free market the yield curve would always tend to be flat. If a difference between long-term and short-term rates emerged then arbitrage would eliminate the difference. Say, for instance, short-term rates began to rise, then investors would desert long-term rates in favour of short-term rates. This would see short-term rates fall and long-term rates rise until the curve was flat.
What the vast majority of commentators overlook is that it is the central bank that manipulates short-term rats. When the economic consequences of this manipulation forces the bank to slap on the monetary brakes interest rates rise and the economy goes into recession. Note: it is the monetary tightening that brings the boom to an end. The rise in short-term rates is just a symptom.
Some have it that the current movement in the yield curve is the result of investors speculating that the Fed is about to loosen the monetary spigot to rescue the housing market. This means that investors are selling long-term bonds and buying short term notes that would benefit from a rate cut. Be that as it may, this action, if it is occurring only serves to confirm our view that in a free market arbitrage would ensure that the curve remained flat.
At the end of March the federal funds rates was 5.26, which is only about 2.5 per cent in real terms. On 9 April 3 month notes were 5.03 per cent while 30-year bonds stood at 4.92 per cent, a difference of 0.13 per cent. So what does all of this tell us about recession? Not much really. Economic figures have to be interpreted. Now many people would see these rates as stimulating output and hence GDP. But there are other factors at work.
The effect of artificially lowering short-term rates is to mislead business into thinking there are more savings available then actually exist. This leads to a pattern of investment in the higher stages of production that cannot be sustained by the real rate of savings. Eventually the process reverses itself and the demand for consumer goods starts accelerating as real wages rise. It is at this point that manufacturing output tends to slowdown and eventually go negative. In the meantime manufacturing employment drops while aggregate employment rises.
This is the classic pattern of boom and bust and the one that marked Clinton's last term of office. When this pattern emerges commentators are likely to lament the weakening of capital spending, thereby successfully confusing cause and effect. But what they should be looking at is spending of fixed capital but spending on 'circulating' capital, otherwise known as intermediate goods. Therese are the goods that pass from stage to stage. Now, having said that, do the facts fit the theory?
During the last 9 months of 2006 inflation-adjusted expenditure on capital goods, factories as well as machinery, grew by 3.9 per cent per quarter. The previous three quarters witnessed an average of 8.2 per cent. Moreover, statistics for January and February indicate a severe drop in orders for capital goods. In addition, manufacturing has been shedding labour. Nevertheless, it is reported that in March the economy generated an extra 180,000 jobs driving the unemployment rate down to 4.4 per cent.
So where are all the jobs coming from? Austrian economic theory predicts that the additional jobs will appear at the lower stages of production, those closest to the point of consumption. As expected, we find that educational services, leisure and hospitality companies, retailers and health care providers, etc., were among those occupations where the demand for labour rose significantly. Clearly increased consumer spending is making itself felt. (It should be pointed out that increased spending on consumption goods does nothing to raise the marginal productivity of labour. Something that the classical economists fully understood). All of this brings us to the money supply. From October 2005 to the end of last March money supply (currency, demand deposits and other checkable deposits) rose by 4 per cent.
Now to top it all off, it has been reported that businesses plan to increase capital spending by 7 per cent during the next 12 months as against 4.9 per cent in December. So what gives here? Off hand I'm inclined to think that the Fed may be loosening money policy. Furthermore, large profits and low capital gains taxes may very well have extended the boom.
For those of you who think I might be hedging my bets -- I don't blame you for being suspicious. But let me draw your attention to three economic events that illustrate why one should always exercise prudence in these matters. In 1923 the US economy began to experience a mild downturn. Left alone the market would have easily liquidated the malinvestments. However, the Fed quickly reversed the situation by rapidly expanding credit. Therefore those observers who were led by the data to believe that a recession was imminent had to wait until 1928 to have their warnings about the state of the American economy confirmed.
In the 1920s the Fed used open-market operations to mop up 'excess' liquidity. Yet credit kept on expanding. The reason was two-fold: firstly, open-market operations were more than offset by a low rediscount rate that allowed banks to replenish their reserves and so expand credit further. Secondly, new banking rules not only allowed interest to be paid on time deposits it also reduced their reserve from 7 per cent to 3 per cent. The result was that banks were able to expand credit further by converting demand deposits into time deposits.
My third example comes from Australia. I had been predicting that the country was heading for a recession. In early 1999 business investment dropped and the current account deficit blew out to 5.2 per cent of GDP. Things were looking grim. Then the March quarter for 2001 showed that manufacturing output had fallen by 2.2 per cent, a figure that exceeded industry predictions and which followed successive falls in the December and September quarters. Furthermore, output had been falling during the previous 12 months. Firms were cutting back on investment, shedding labour, introducing short-time working, and profits were declining.
Naturally I declared that the jury was in that Australia was in recession. The Reserve Bank of Australia then did what I should have expected it to do and let the money supply rip. It cut rates from 6.25 per cent to 4.25 per cent, a full two per centage. M1 rocketed by 22 per cent and credit exploded by 25 per cent.
So before readers start making predictions at this stage about the US economy, I strongly suggest that they recall their economic history and continue to bear in mind the monetary power of central banks.
Note: The Austrian definition of the US money supply is currency outside Treasury, Federal Reserve Banks and the vaults of depository institutions.
Demand deposits at commercial banks and foreign-related institutions other than those due to depository institutions, the U.S. government and foreign banks and official institutions, less cash items in the process of collection and Federal Reserve float.
NOW (negotiable order of withdrawal) and ATS (automatic transfer service) balances at commercial banks, U.S. branches and agencies of foreign banks, and Edge Act corporations. NOW balances at thrifts, credit union share draft balances, and demand deposits at thrifts.
AMS definition therefore equals cash plus demand deposits with commercial banks and thrift institutions plus saving deposits plus government deposits with banks and the central bank.