Connelly on Commerce

Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

 Two headlines from today’s AP wire say it all: Another New Low for the Doillar; and Oil Near Record as Dollar Falls.

 One of the immediate “unintended consequences” of the Federal Reserve’s rate-cutting  response to the threats to US economic growth posed by the housing/credit crisis has been a continuing fall in the US dollar’s relative value against major global, and even many largely local, currencies.  At the same time, the price of oil on world markets has risen to a level now $20 above where it was a year ago, even as inventories in the US have turned runed slightly upwards and the hurricane season continues to pass without any major damage to production or refining capacity.

 Some of the oil price action is undoubtedly a result of speculative investment that will be sold off at some point, bringing price action down. But the reason for this speculation is clear — expectation of higher overall prices of commodities due to a continuing decline in the currency in which those commodities are priced.

Absent a decision on the part of oil producers to insist on payment in Euros rather than US dollars (see my recent post “the Subprime Dollar”), it would seem that in due course (though not yet) these higher oil prices will be passed along to the gas pumps and US consumers will feel yet another pinch in their wallet. And this time it may just tip the balance in favor of changing their behavior to opt for less driving altogether — the kind of “‘demand destruction” we have not experienced in the gasoline market for some considerable time.

 It is precisely this kind of behavioral change that the advocates of carbon taxes are seeking to achieve, but so far have found very few political sponsors (the long-term Michigan Congressman JohnDingell being one exception, but he may just be kiddingin an effort to call out the obvious lack of popular support for such proposals.)

Given the apparent absence of political will to force consumers to amend their driving habits even to reduce the flow of funds to sponsors of terrorism, evironmentalists may come to see the Federal Reserve as the latest example of public officialdom adopting  the “clean and green” label.

A lower dollar accomplishes a good deal of the impact of a carbon tax without the need for legislative action — those messy processes called democracy. While oil priced in dollars actually becomes somewhat cheaper for drivers living in other countries, US consumers will be forced to pay more for their driving privileges — the only problem is that, unlike the case of an actual tax, the increase in the price of gasoline due to the lower dollar accrues to the oil supply chain, not to the government as an offset against some other tax (many advocates of carbon taxation specify scenarios that would be “revenue neutral” to the government by allowing for equivalent reductions in other taxes on consumers).

A further reduction in the Federal funds rate on Halloween by the Reserve Board would seem likely to advance the cause of higher gasoline prices — scary for consumers, but a possible “green pumpkin” for the environment.

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Be careful what you wish for. The US equity market has responded positively to the Federal Reserve’s 50 basis-point reduction in the Federal funds rate, primarily because it senses that the Fed now “get’s it” in terms of the risk to the economy  posed by the severe credit contraction in recent weeks. The market simply did not broadly agree with the Fed’s assertion of early August that the predominant risk to the economy going forward was inflation. Note, however, that the Fed continued to cite the reality of the inflation threat even as it cut rates boldly in an effort to head-off a downward spiral of market and consumer psychology.

The question now shifts to whether the equity market “get’s it” in terms of the risks to the economy going forward posed by one of the most prominent “side-effects” of the Fed’s dose of anti-depressant interest rate cuts — namely, the continued spiral down of the US dollar’s relative value in the global currency markets.

In the short run, the dollar’s decline has shown a positive effect in terms of helping to reduce the huge US trade deficit caused by our importing more than we can pay for out-of-pocket (which has led us to borrow heavily from the dollar accumulations in the hands of  those economies that export the most to us like China and the oil economies of the Middle East). This recycling of “petro-dollars” and “Wal-mart dollars” is nature’s way of imposing a balance, and it has overall had the effect of restraining inflationary pressures in the US to some extent. Moreover, it is at least arguable that, if the Fed’s interest rate cut and possible further cuts helps secure a soft-landing and quick bounceback for the US economy, the dollar should strengthen and the global recycling machine will be up and humming again.

But in any imbalance, there can come a “tipping point”, and the reaction to the Fed’s move in the currency markets may be bringing us closer to one which could reverse the so-far positive consequences of the lower dollar for the US economy. 

Not surprisingly, the fulcrum for that tipping point could well be oil. That commodity, like many others, is priced in US dollars, and those who sell it like the Saudis have tended  to manage their domestic currencies with an either explicit or implit linkage to the American currency to smooth out potential gyrations in their own economies.

Perhaps it has not been sufficiently noted, however,  that the Saudis did not make an equivalent adjustment to their interest rates after the Fed made its cut this past Tuesday. Could this be a signal that the Arabs are running out of patience with pricing oil in dollars as the Euro continues to move toward more promise as  a medium of exchange (not that there is anything else going on in their neck of the woods that might trouble the Arabs about US behavior and interests)?

Imagine a world in which a new “gas tax” was added to the price at the pump for US drivers — namely, the currency exchange premium necessary to convert US dollars into Euros just to buy the oil in the first place. While this might thrill the hearts of those concerned with global warming, it could also lead to a myocardial infarction in US economy  with a renewed risk of inflation due to escaling prices of all commodities priced in dollars, and a subsequent slowdown in GDP growth that would make the housing credit crunch feel like  minor heartburn by comparison.

The Fed may have had no choice but to take the action it did to stave off the more immediate threat of a psychological melt-down among US consumers (or, at least, among equity fund managers). But in kicking the dollar can down the road, the Fed may have scored an “own-goal” for the inflation team, and it will need a partner or two to help manage the currency consequences of its action. Look for Treasury Secretary Paulson to make one of those famous Treasury-Secretary “we support a strong dollar” speeches one of these days soon.

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Terry Connelly is dean of the Ageno School of Business at Golden Gate University and is frequently quoted on business, financial, and economic issues by Bay Area local, as well as national, news media.

The famous Mr. Dooley once suggested that, despite its independence and insulation, the Supreme Court nonetheless “watched the election returns” (more recently it even got involved in determining the election returns). The Federal Reserve enjoys a certain degree of independence from its political and commercial constituencies as well, and is not supposed to “watch the share markets” in setting monetary policy.

Nevertheless, the equity market has been trying to get the Fed’s attention for some time this summer to convey the sentiment that the problems in the mortgage and broader credit markets portend a greater risk to the economy going forward than inflation. On Tuesday next, we will see if the Fed has taken that message into account both in setting the Federal funds rate and in its accompanying explanatory statement.  

Some inkling of a slowdown in consumer spending was evident in today’s retail sales figures for August, but there was enough curiosity about the data to suggest that it may be unreliable as an indicator of sentiment going forward. But consumer confidence also remains soft. What may be at work here is a secondary effect of the recent share market “messaging” to the Fed in terms of the 10% correction against the all-time-high on the Dow and the subsequent daily volatility ever since.

If consumers generally are getting the sense that they may be losing not only their home equity ATM machines of the past few years but also their 401(K) and IRA safety nets (folks just don’t trust in Social Security any more), then the August retail trends could turn even worse in the near term rather than reverting to norm after one aberrant month. So while the Fed should not be bailing out investors in any market, one suspects they may take a peek at the share markets enough to consider the likely market ramifications of any failure to cut the funds rate at least by 25 basis points next week while continuing to signal they stand ready to act to prevent a serious risk of economic downturn. The economy does not need a 1987-style stock market crash to go along with the credit crunch.

And while we’re busy watching the Fed and brokerage firm earnings next week, let’s also watch what happens in Japan with the selection of a new Prime Minister, and his likely policy proclivities toward that country’s central bank “independence”.  At least one of the leading candidates favors more autonomy for Japan’s monetary authorities, some of whom have been suggesting the possibility of a rate increase that could spark further runs on the so-called “carry-trade” (another aspect of the “credit Olympics” of the past four years or so), with significant implications for the US dollar and all that implies for good or ill in our economy.  Globalization cuts a lot of ways.

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The stockmarket today went straight downhill after the announcement early this morning of the surprise decline in employment in August of a net 4,000 jobs (out of a total of over 138  million) when expectations had been for a gain, in line with recent months, of a bit over 100,000. Worse, prior months’ data was revised downward by about 90,000, too.

One can speculate reasonably that this morning’s data will itself be revised either up or down in next month’s report, but by then the effect of the present data will make those adjustments, if any, irrelevant. The markets (actually, both stock and bond) have been having a tug of war with the Federal Reserve for some time now over whether the primary threat to the economy going forward is inflation or recession. The Fed blinked a bit in the face of the credit “freeze” brought on by the subprime meltdown and risk repricing of early August by lowering its own interest rate charges to banks seeking liquidity options, but has yet to change its targeted “Federal funds” rate for overnight commercial lending in the face of concerns that it would only be bailing out speculators who made improvident bets on subprime and adjustable-rate mortgages (either as borrowers or lenders or investors)  — the so-called “moral hazard” dilemma. 

Today’s jobs report gave the market its excuse to posture a panic mode of recession fever in a continuing effort to convince the Fed that, like inflation, even the moral hazard risk must take a back seat to the threat of an overall economic contraction as a result of the knock-on effects of the decline in housing-related commerce and finance (which are really only intimated in a small way in today’s jobs report).  

The 249-point decline in the Dow and similar falls in the NASDAQ and S&P 500 indices were not literally panic selling (although some companies’ shares no doubt were oversold in the rush to the exits and will bounce back in due course). Rather, the market in its own crude way was sending a “message” to the Fed (which had just issued its periodic “beige book” report on economic activity in the various regions of the country which noted only limited effects of the housing contraction on the overall economy). 

At bottom, the markets want the Fed to be just as “preemptive”  — in terms of lowering the funds rate — when faced with early warning signs of recession as it has long professed to be, in terms of increasing rates, in the face of early warning signs of inflation.

But recognizing the downward drift of the US dollar’s value, one might caution the markets to be careful what they wish for. Therein lies the coming weeks’ debate — should it be a 25 basis-point cut, or 50?

The market’s message was not unlike a brush-back pitch in the late innings of Yankee’s-Red Sox game in the pennant race. Sure, the pitch may have ‘slipped’ today, but “there’s more where this came from” (if you don’t cut rates significanctly, and soon). In this sense, the jobs report was to the market a “gift that keeps on giving” for the next ten days or so until the Fed announces its decsion on rates on or before September 18.

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