Rates on the rise
Politics unusual redux.
Michael Farr
Sept. 16, 2004
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The economy continues to strengthen, and stock valuations continue to come down, yet neither consumers nor investors feel optimistic. Having good numbers does not seem enough to sway voters or stock market participants. It seems that both interest groups share dour financial views and need to be sold on the sunshine surrounding them.
Seeing appears insufficient for believing. George Bush may have a good economy on which to run for President, but what is it worth if no one believes in it?
Federal Reserve Chairman Alan Greenspan recently told Congress that the economy is still growing, and that the apparent slowdown in late spring "no doubt is related, in large measure, to this year's steep increase in energy prices." Greenspan went on to say that more recent data suggest the expansion has since "regained some traction." Key metrics such as consumer spending, housing starts, business investment, manufacturing output, and employment all strengthened in July. Furthermore, key gauges of inflation (as well as expectations for future inflation) have eased in recent months, which should allow interest rates to remain near current low levels.
Greenspan stated that higher energy prices were largely responsible for higher levels of inflation earlier this year. More recently, however, demand for gas has subsided somewhat as a result of higher prices. The reduced demand has led to an improvement in inventories and lower prices at the pump in the short term, but this story is far from over. The long-term outlook for oil prices, Greenspan says, remains uncertain due to supply concerns and expected economic growth in developing countries such as China and India.
Another area of wide concern among economists is the federal budget deficit. According to Greenspan, "the deficit is more likely to decline than to increase in the year ahead" as the economy improves. While we are uncertain about the absolute dollar value of the deficit next year, it seems likely that the deficit as a percentage of GDP will drop as the economy continues to grow.
Greenspan goes on to say, however, that the longer term outlook for the budget deficit is troubling. He warns that "with the baby boomers starting to retire in a few years and health spending continuing to soar, our budget position will almost surely deteriorate substantially in coming years if current policies remain in place." Greenspan suggested a renewed commitment to the Budget Enforcement Act of 1990, the key provisions of which expired in 2002, as one tool in a comprehensive effort to restrict government spending in the future.
Healthcare costs appear to be a key culprit in our surging budget deficits. Certain government sources estimate that health spending is responsible for more than two-thirds of the increase in deficit spending.
Greenspan believes our longer-term federal spending commitments require better forecasting and adherence to strict disciplines. He points out that in 2008, the earliest members of the Baby Boom generation will turn 62, which also happens to be the earliest age for claiming Social Security retirement benefits. By 2011, they'll reach Medicare eligibility. The Fed chairnan has predicted that within 26 years, outlays for those two programs will consume almost 14 percent of GDP.
Keep in mind that Medicare costs are especially difficult to forecast because of unknown healthcare cost increases and possibly longer life expectancies in the future. "It is, therefore, imperative to make clear what real resources will be available so that our citizens can properly plan their retirements," Greenspan has said. "Re-establishing an effective procedural framework for budgetary decision making should be a high priority."
The Presidential candidates have opposing views on the best way to address our long-term fiscal health.
Sen. John Kerry (D-Mass.) says that Social Security should not be privatized. President Bush has called for individual ownership and control of Social Security accounts.
Kerry says the budget deficit is a problem and must be addressed by eliminating the Bush tax cut for those making more than $200,000 annually, and thereby increasing government revenues. Bush wants to leave the tax cuts in place and says GDP growth can reduce the significance of the budget deficit.
Large deficits for countries, corporations or individuals are not good things. While some debt is fine, less of it means a stronger balance sheet. The current U.S. budget deficit is 4.2 percent of GDP. While that is significant historically, it was equal to 6 percent of GDP in 1983. We may grow our way out of debt via an expanding economy, but not if we continue to increase spending. Increasing taxes is restrictive fiscal policy and will serve as an economic drag. It may be prudent to increase taxes at some point, but the economic recovery seems too fragile to do so now. Limiting spending is the key.
Consumers feel bad because they are not experiencing the economic recovery that is being touted in the headlines. However, those consumers never really felt bad during the recession itself, and in fact, they kept the economy alive. Consumers continued buying new cars, new homes and big screen televisions. Low interest rates allowed consumers to borrow their way around financial pain.
In the end, I believe that the numbers will win out. Greenspan said in September that "As yet, concerns about the budget do not appear to have left a noticeable imprint on the financial markets." While this may be true, something is holding back equity valuations at a time when the short-term data suggests that we are in an economic recovery.
Are investors finally beginning to take a more long-term view and heed Greenspan's warnings about our growing national debt, the precarious situation in the Middle East and the prospect of significantly higher oil prices in the long term? It's unlikely -- but these influences must eventually be rectified before the markets can move significantly higher.
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