In the second half of 2011, the US economy bucked the general trend and stood out as the only major region where growth actually accelerated. The first few months of 2012 reaffirmed this. However, the weaker-than-anticipated employment data for March 2012 (non-farm payrolls printed in at 120K against expectations of 221K) took away some of the excitement that had built up about future growth prospects. Even as the disappointing release probably reflects a correction in the unusual surge in jobs growth in previous months, the renewed concerns are perhaps justified. After all, the US economy had showed tentative signs of recovery twice earlier (in 2010 and 2011) only to disappoint. Weaker growth forced the Federal Reserve to take strong monetary steps to address the softness in growth on each occasion. Key questions at this stage are: will history repeat itself for a third year in a row? Will the Federal Reserve be forced into an accommodative stance yet again and will the dollar succumb to the pressures of monetary expansion?
There are some important differences this time with the growth patterns witnessed in the two previous years. For one thing, US domestic demand appears to be on a much firmer footing. Private consumption picked up quite sharply in the last quarter of 2011 as US households dipped into their savings to increase spending on durable goods. Employment prospects certainly look much better (the unemployment rate has come down by roughly a percentage point over the past year) and with the Fed virtually guaranteeing unchanged interest rates, the outlook for private consumption looks quite promising. Another encouraging sign is the pick-up in bank credit growth and this might just be telling us that the private demand uptick is likely to last. Overall, bank credit has grown by four per cent in February, 2012. The improvement is visible not only in industrial loans but also in consumer loans. The revival in credit indicators does show that US banks are finally getting over their reluctance to lend. Finally, the housing sector is showing tentative signs of bottoming out although it will take some time for the downtrend in house prices to reverse.
Even though private demand is likely to grow at an improved pace, a spectacular pace of growth is still unlikely at least for the next few years. There are still a number of headwinds that will act as natural dampeners. Households are still “repairing their balance sheets” (a process that started in the wake of the subprime crisis) and according to most analysts, they still have some way to go before reaching a sustainable balance. This sets a limit on the amount they would want to borrow to spend.
Second, the US cannot grow beyond a point without a helping hand from Europe. Potential risks from the sovereign crisis still remain and could feed through to the US through financial and real channels. If there is a fresh round of risk-aversion on the back of growing jitters over Europe (say, Portugal or Spain requires more financial assistance or the prospect of a break-up of the currency union looks more probable), it would affect the US stock market and household wealth in the process. On the real side, a full-blown recovery is unlikely unless US manufacturing exports to Europe perk up. That seems unlikely given the tepid forecasts for European growth for the next couple of years that most analysts and institutions share.
The bigger risk perhaps comes from fiscal consolidation in the US itself. The process of getting government debt back to more manageable levels (from current levels of 100 per cent of GDP) could intensify as a new administration takes over. Consolidation would mean higher taxes or lower spending or both and this will be a drag on growth and incomes. Given these risks, the best case is that the US grows around a trend-rate of 2.5 per cent for the next few years.
How could the Fed respond? If the recent growth momentum continues (and the perceived setback in March reverses quickly), it will find it difficult to justify further monetary expansion. However, increases in interest rates are likely to be off the table until 2014. The Fed has a dual mandate of ensuring both employment and price stability. It might be a while before the unemployment rate (currently 8.2 per cent) reaches the level of 5.5 to six per cent consistent with the Fed’s employment mandate and that will hold it back from changing its interest rate stance. Besides, one cannot rule out the possibility of another bout of quantitative easing in the medium term if the current recovery plateaus and a new round of fiscal correction commences. But for this to happen, the Fed needs to first get a handle on the fiscal management strategy going forward and then make an assessment of its impact on growth. This one can perhaps rule out “QE3” before 2013.
What are the implications for the dollar? While the dollar did lose some ground in response to the March employment report, sustained dollar weakness is unlikely in 2012. The dollar is likely to benefit from both an improving growth outlook and reluctance of the Fed to turn accommodative. Improving US growth prospects could increase the attractiveness of US assets in a situation in which both emerging economies and the euro zone slow. This might force US investors to bring money back home, lending a natural support to the dollar. At the same time, if the Fed stays on hold and other central banks expand money supply, the dollar also enjoys a relative interest rate or “yield” advantage.
A reversal in the dollar’s trajectory could come if the prospect of QE3 looks brighter and emerging market economies show signs of picking up. This could entice fund flows back into the emerging market region ensuring that dollar depreciates but that is likely to happen only in the fourth quarter of 2012. For now it seems that the dollar has the upper hand. More rupee depreciation on the cards, then?
The authors are with HDFC Bank. These views are personal
