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Monday, June 4, 2001

U.S. also caught in liquidity trap


On May 15 the United States Federal Reserve Board announced that it would cut short-term interest rates by half a percentage point. It was the fifth rate cut this year and brought the total amount of monetary easing to 2.5 percentage points.

The stock market did not greatly react to the rate cut that day, for it had been widely expected. But the market later rebounded after the release of economic indicators on price stability, apparently sensing the possibility of another cut.

This sort of reaction indicates that the psyche of the market is wavering between the worsening of the actual economy that is behind the rate cuts, and concerns of inflation, as can be seen in rising gasoline prices.

It can easily be imagined that FRB Chairman Alan Greenspan's decision to cut rates in half-point stages every month, despite criticism that such actions were "too little, too late," was based on concerns about inflation.

Therefore, it would appear that price trends hold the key to monetary policy. But I believe there are six points to watch in future indicators.

First, U.S. wholesale prices are rising by 3.7 percent. While much depends on future movements, there is little room left for monetary easing. If, as some players hope, there is another cut in rates, it will effectively be made at zero. Second, both traditional economic sectors as well as those categorized as being part of the "New Economy" are saddled with excessive equipment and facilities.

Under such circumstances, very little can be expected in the way of boosting investment through lower interest rates. This is because as global competition further intensifies, there will be few companies willing to add to their excessive stockpiles of equipment in the U.S., no matter how low rates are. Even if some firms opt to increase investment, this would likely take place overseas, especially in developing nations, where costs are cheap.

Third, the amount of nonperforming loans held by U.S. financial institutions is on the rise. As of the end of March, the amount of sour loans grew roughly 10 percent from the end of last year. This trend continues despite interest rate cuts, and there are even rumors of some credit crunch and hike in lending rates.

Fourth, latent profits on stockholdings have decreased while savings, on the other hand, remain at levels near zero. Many firms have announced restructuring plans, and as those programs become more specific, we should watch movements in consumer spending, the largest component of GDP.

Fifth, future fluctuations in long-term interest rates, which are not easily affected by the policies of the central bank, also need to be monitored. The yield on 10-year Treasury bonds, which at one time had fallen to levels around 4.5 percent, have recently risen to around 5.5 percent. This reflects the limits of credit easing and the possibility of future inflation. This rise in long-term interest rates, coupled with the macroeconomic slowdown and the decline in corporate earnings, forms the backdrop against which stock prices are falling. This could also lead to a vicious circle in which lower stock prices affect consumer spending.

These observations lead me to believe that the U.S., just as Japan, is falling into the liquidity trap.

Sixth, we also need to keep close watch on the effects of President George W. Bush's tax cuts. While it is true the public sector has some leeway, the private sector is very short on savings, and in total, the country has not saved enough. This is reflected in the massive deficit in its current account balance, and this is where the weakness of the U.S. economy lies (My Japanese Perspectives, Jan. 15).

Whether American consumers decide to spend or save their $600 tax rebates this fall must be watched very closely.

Teruhiko Mano is an adviser to Tokyo Research International Ltd.


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