| AN ECONOMY IN A PROCESS OF DISINFLATION |
| The big economic question these days is whether the weakening economy will survive the strains or collapse under them. Can the Federal Reserve do enough to avert a recession?" asked Brian Bethune, economist at Global Insight. Between 1996 and 2000, the US economy experienced neither significant unemployment nor inflation. Further, the US economy slowed substantially in early 2001. After the Sept. 11 attack and following the massive layoffs in the travel industry in October 2001, in addition to the raisings concerns of a possible decline in real Growth Domestic Product, White House, Congress and Federal Reserve delivered an economic boost in order to prevent a serious economic downturn. The Bush Administration and the Congress explored possible tax rebates and pledged to increased Government Spending; Federal Reserve pledged to lower interest rates as needed. As expenditures exceeded revenues, the Government recorded a deficit. The Treasury followed its customary procedure of financing budget deficit since 1941 by issuing and sold securities. Federal Reserve Open-market Sales increased the demand conditions of the market for Government Securities with an impact on their market price and their yield. Federal Reserve open market sales increased the supply for securities, decreased their market price and thus raised their yields. Investors and banks draw their money from the stock market which started turning downward in the mid of 2000, after soaring to unprecedented highs between 1997 and 2000. As the Government wrote checks, the funds got back to the public and increased ordinary demand deposits held by commercial banks. At the same time, the Federal Reserve initiated a series of cut in the discount rate until the rate reached 1%, allowing the commercial banks to obtain direct loans secured by collateral of Government Securities. Cuts in the discount rate added to the open market activities of the Federal Reserve working in harmony with the Department of Treasury, increased the money supply, the reserves of funds at the commercial banks and led to the expansion of credit by these banks. As rent were increasing (4% - 6% a year) because of the flow of immigrants, particularly those crossing the US/Mexican border, Investors started borrowing money to invest in Real Estate which represented at that time 2002-2003 the one of the highest yielding assets. In response to actions of the Federal Reserve, interest rates dropped to their lowest level in decades: from 9.9% during December 2000 to 4% in July 2003. As the best clients of the banks, beneficiaries of the Prime Rate of interest could not absorb the amount of funds available for credit, the commercial banking system started to finance the purchase of home for clients with blemished and limited credit history at a rate higher than the prime rate and the subprime lending market expanded, backed by Institutional Investors. The rapid increase in the demand for houses pushed housing price higher and higher; new construction and sales of existing homes surged. Building permits for construction of new houses represents one of the ten leading indicators the Conference Board’s Index of Leading indicators has usually used to forecast the future direction of the US economy; as the number of buildings permit was increasing along with positive consumer expectations, the economy initiated a cycle of growth. Consequently, in order to prevent and manage inflation (to much money to purchase too few goods and services), the Federal Reserve involved in increasing the discount rate, starting in the summer of 2004 to bring it back to 5.25% ; the incremental increases in the discount rate maintained the rate of inflation at a moderate pace in 2004, 2005 and 2006 . But, by September 2007, economic data started giving sign of an economic downturn. High inventory of houses for sales following the slowdown of the Housing Market since 2006 – 2007 caused a drop in sales price; hundred of thousands homeowners hold mortgage higher than the value of their house. By the 4th quarter of 2007, 1.3 millions of homeowners beneficiary of the Subprime Lending Market faced serious delinquency on their mortgage payment. With the collapse of the housing boom, nearly 8.8 million homeowners, or 10.3 percent of the total, are underwater, according to a new estimate of the damage by Moody’s. The lending market has already wiped off their balance sheet an estimate of 350 billions dollars of subprime Loans.These lost of funds following serious delinquencies of mortgage payment and the number of foreclosure registered, may cause a massive lay-off in the financial industry like it happened in the travel industry after 9/11. Raising concerns of a possible recession pushed the Fed to start again a series of rapid cuts in the discount rate from 5.25 in September 2007 to 3%, with a slash cut by three quarters of a point, two weeks ago. Progressive decline in the discount rare represents a sign of potential recession; recent statistics support the potential risks of a recession: the increased consumer price index, rising unemployment, lower personal income, and drops in home prices, retail sales, housing starts, and manufacturing activity. At the same time, the White House has presented a package including: 150 billions of dollars of tax rebate to taxpayers with an annual income of less Government funds to guarantee, purchase and refinance billions of dollars in mortgage for trouble homeowners. Martin Feldstein, a former President Reagan's top economic adviser, and former Federal Reserve Chairman Alan Greenspan have urged greater government intervention. Feldstein suggested "some form of investment incentive" be included in the stimulus bill, like accelerated asset depreciation; he said the transfer of money to state and local governments would be a "slow and complex process," as would new spending on infrastructure. Cuts in the discount rate combined with efforts of the stimulus package of the Busch Administration aim at reducing the loss of the institutional investors who backed the subprime loans, allowing banks to expand credit and increasing consumer spending. Based on the High Inventory of Houses for sale, the decrease in the price of some consumer goods, the increase in the price of basic materials and agribusiness commodities, Capital Seeds Corporation forecast a process of disinflation, “which is a slowing in the rate of inflation, while the general level of prices are still increasing” (definition drawn from search.com), but slower than before. Ben Bernanke said he “expected inflation to moderate in coming quarters." In addition to what Ben Bernanke said, we lay our position on the fact that following the credit problem: there is too few money to purchase too much inventories, so the Federal Reserve in harmony with the Department of Treasury is adjusting the money supply to allow investors and consumers to purchase the excess of inventories. If the actions of the Fed and the Treasury department do not make the correction and absorb the excess of inventories, at that time, the economy could initiate a process of Deflation which is a decrease in the general price level over a period of time and the recession will be evident. At Capital Seeds Corporation, we also forecast that the fresh money will be invested in stocks related to new order of capital equipment and basic materials and financial. The new order for capital equipment that banks will finance will be used for repair and construction of public and private infrastructure that will increase future aggregate demand and push up Real Growth Domestic Products; that’s the reason why institutional investors are currently rushing into basic material and agribusiness commodities as classic investments. Increase in the prices of Agribusiness commodities (corn particularly because of its use in production of ethanol) could represent an opportunity for Low Income Developing Countries to make money from the Global Market. Using inflation spread model taking into consideration the price of Gold (8 Quarters Lead), the money supply (8 Quarters Lead) and the 5 years Spot (7 Month Lead, used by the Fed to forecast inflation), Stefan Abrams of Bryden-Abrams Investment Management and Larry Kudlow from Kudlow & Company forecast that the series of cut undertaken by the Fed (Caeteris Paribus) will produce inflation to 3.4% - 3.5% by 2009. They suggested that the Fed holds the rate at the actual level of 3% for 6 consecutive months and watch the evolution of the economy before making any further move. |