Unless You Own Gold
This is a follow-up to last Wednesday's discussion. After the Fed cut the Fed Fund's rate by another 0.25% last week, the Wall Street Journal's online poll indicates:
It wasn't a scientific poll, but the 59% (48%+11%) majority disapproval told us the latest rate cut wasn't well received. And Ben Bernanke, Wall Street's beloved "genius" that saved Wall Street on September 18 by conducting the highly praised "surgical strike" is now called an irresponsible nut by the same group of people.
Behind the scene though, members of the Fed might've been congratulating each other for a job well done, particularly after the release of the 3rd quarter advance GDP report. The Bernanke Fed had accomplished what the Greenspan Fed had failed to do during the 2000-2001 recession. Real GDP increased at an annual rate of 3.9 percent in the third quarter of 2007. That's up from 0.6% in the 1st quarter and 3.8% in the 2nd quarter. Current-dollar GDP also increased 4.7%, or $157.9 billion, in the third quarter to $13,93 trillion.
We all know that PCE (Personal Consumption Expenditures) is about 70% of our GDP. When this major component of GDP slows down, our economy slows down. That's what happened in 2000. PCE year-over-year change dropped all the way from above 8% in 2000 to under 4% in 2002 (see Chart 1 below). Subsequently, GDP growth went negative, and the economy slid into a recession. Last year, after having stayed mostly above the recovery high of 6% for about 10 quarters (triple-top formation), PCE appeared to be forming a new downtrend again (lower highs). This time, however, GDP number did not falter.
When PCE dropped below 7% in Q3 of 2000, real GDP growth rate declined to a negative 0.5% (see Chart 2 below). This year PCE had already declined to 5.16% in Q3, yet GDP grew 3.9%. The difference? The Dollar.
In 2000, the Fed's Major Currencies Dollar Index was well above 100 and rising. As of Friday, 11/2/2007, the same index was at all-time low of 72.2171 and falling (Chart 3 below).
There's not much anyone can do about the structural shifts of PCE. Once this largest component of GDP goes into a structural decline, the trend normally doesn't get reversed right away. The 2nd largest component, the Government Expenditures and Investment, has also been structurally fixated at around 18%-20% of GDP through the years. There's not much room for maneuvering either. Private Investment, another GDP component, has shown declining pattern similar to PCE after the 2004-2005 top. Residential housing market bust plays an important role in its demise. And, that, too, does not go into reversal right away. The latest current-dollar gross private investment had declined $100 million from Q2. That leaves us, and the Fed, with just one component, Net Exports.
Current-dollar Net Exports had shown 2 consecutive quarters of improvements, which was unheard of since 2001. The improvement in 2001, nonetheless, was due primarily to the declining consumption demand for imports. This year, both imports and exports had been growing. The improvement this time in net exports is due mostly to the declining Dollar. The increase of $77.3 billion in exports from Q2 was the largest quarterly increase ever. That's almost half of the $157.9 billion quarterly increase in GDP. This component of GDP appears to be most responsive to monetary policy manipulation.
In 2000, while PCE was losing the steam, the Dollar was still in an uptrend (revisit Chart 1 & Chart 3 above). Rising Dollar made exports of American goods and services more expensive and less competitive. As U.S. net exports sank deeper into the negative territory, the growing deficits of negative net exports continued to be subtracted from GDP. Net exports' downward spiral went on till 2001 (see Chart 4 below) when the Fed Funds Effective Rate began to fall off the cliff. The Fed Funds Effective Rate fell sharply from above 6% in the beginning of 2001 to 1.19% in September. Although it was a little tardy, the rapid successive rate cuts did revive this most responsive GDP component almost instantaneously. This then paved the way for the recovery in the final quarter of 2001.
Even though net exports started to slide again in 2002, by then the low-to-no cost of borrowing had already gotten the consumption going again. The recovery of PCE made up more than enough for the losses in net exports. And the economic recovery was well on its way.
The Fed remembered the lethal combo of strong Dollar and weak consumption that threw the economy into a recession in 2000-2001. As recent PCE began to show signs of slowdown again, the Fed's doing whatever it can to avoid the same pitfall. It moved very quickly and proactively to manipulate the same GDP component that produces fast results. The lavish gift of a 0.50% rate cut in September provided an immediate turbo boost to the supply side of the equation (see black arrow on Chart 4). And, despite Wall Street cheerleading squad's discontent, another 0.25% cut last week should further improve exporters and multinational conglomerates' bottom lines.
If GDP continued to be dragged down by declining PCE and the slumping housing market, which remained as a liability of the gross private investment, the Fed would have little choice but continue to devalue the Dollar. The strong Dollar policy is but a fib. Whether this is hurting Main Street more than it's helping Wall Street, the scheme appears to be tweaking GDP numbers into prosperity. It may continue to work, that is, until we set ourselves up to becoming Japan #2.
Japan's export-led economic growth policy has, in most part, neglected domestic demand. And, according to Harvard Business School professor, Michael Porter, "as Japanese companies encountered limits on exports and expand their foreign investment, slow domestic investment and sluggish domestic demand have undermined economic growth." If this all sounds too familiar, then we may have been well on our way. The only, and the biggest, problem is that the Dollar may have to be devalued exponentially. And, we may not have the same low interest rate environment to facilitate any carry trade.
And, the thought of weak Dollar, weak consumption, and high interest rates are just too depressing, unless you own gold.