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Why is Greenspan `Mr Reluctant'?

V. Anantha-Nageswaran

THERE are increasing concerns in the bond market and in market commentary that the US Federal Reserve Chairman, Mr Alan Greenspan, could be leaving short rates too low for too long. It could create an asset market bubble. Unlikely, in my view, since valuations are too low and there is no other external euphoria like it was in the second half of 1990s such as productivity and technology hype. Needless to add, the world is a different place than it was in the 1990s. At the very least, it feels a lot less safe.

Such low rates could stoke inflation. Again unlikely, in my view, for several reasons. The capacity utilisation rate in the industry is around the mid-70s and the unemployment rate is rising towards 6 per cent. Hence, what I call `factor utilisation' (utilisation of factors of production such as labour and capital) is not running high. Normally, that is a good indicator (if not leading, at least concurrent) of inflation.

Second, in the mid-1990s, headline inflation climbed close to 3 per cent in 1996. That was a year in which both oil and food prices climbed very sharply. Such a dual combination is unlikely this time, as food price inflation remains muted.

Why, then, Mr Greenspan appears willing to leave interest rates too low for a long period of time than the market has discounted for now?

I do believe that he is quite concerned about the debt-servicing obligations of the US private sector. I will use three charts to make the following points:

(a) The debt-servicing burden of US households is quite high, if not at its highest level.

(b) The non-federal debt growth rate in recent years has continued unabated and the debt-GDP ratio stands at a historically high ratio.

(c) Much of the recent accumulation in debt has not resulted in higher investment that is normally the key to enhancing the future debt servicing capability of the borrower. The chart showing the ratio of Gross Private Domestic Investment to Non-Federal Debt illustrates this. Private domestic investment includes housing investment too.

Much of the borrowing has been used, by inference, for consumption activities in households and for executive compensation, share buybacks and other running business needs.

Such borrowing was, hitherto, backed up by increase in market capitalisation of financial assets. Now, that cushion is no longer available and only the increase in the value of real-estate is the cushion.

The amount of equity that can be extracted out of rising real-estate values is not that high compared to financial assets and, second, it is easily dwarfed by the recent slide in the market value of General Electric stock alone.

Therefore, Mr Greenspan is very well aware of the fact that he has an `unofficial' and `unstated' credit problem, unlike the Savings and Loans crisis in the early 1990s which was a public one. Therefore, just as the Federal funds rate remained at 3 per cent in the early-1990s for quite a while, before rising in 1994, they will remain at low levels for US private sector balance-sheets to be built up.

This will prove to be a time-consuming task compared to the earlier problem, as there was a federal bailout for the S&L crisis. The Federal bailout has already happened for the US private sector in the form of tax cuts and economic stimulus packages.

Therefore, the private sector has to reduce the mountain of debt through the good old-fashioned belt-tightening, that is, saving. This means that the US economic growth in coming years is bound to be anaemic.

Asset markets will not help for they will be caught in a vicious circle. Excessive investment in capacity, high debt-servicing burden will drill holes in earnings which will make it difficult for loftier valuations to revert to mean, unless prices of equities decline faster. Therefore, support from financial markets is unlikely for this balance-sheet repair exercise on the part of US private sector.

In a sense, Mr Greenspan and his colleagues at the Federal Reserve Board have already smelled the early stages of a Japan style credit-led asset market boom that has bust leaving credit quality repair to be done.

He simply does not wish to repeat the mistake of the Bank of Japan that left monetary policy inappropriately tight in the wake of the collapse of the asset bubble in the early-1990s.

Of course, the policy of leaving interest rates appropriately low to enable balance sheet repair might turn out to be inappropriate from other considerations if, contrary to my assessment and that of the Fed, the bond market develops an inflation scare or rising oil prices force them to do so.

In such a situation, bond yields will rise at the medium to long maturities and will make the risk-return trade-off from equities look even more anaemic in comparison. A declining dollar will complete the picture. All told, Mr Greenspan finds himself in an unenviable situation.

One that he might have avoided had he tightened a tad more than he did in 1997-98. As for investors, at this stage, it appears that the soundest alternative is to diversify out of dollar assets.

(The author is the Regional Head of Investment Consulting in Credit Suisse, Asia-Pacific. The views are personal. Please send feedback to nageswar@singnet.com.sg)

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