US consumer still going strong

In the run-up to this week's FOMC meeting, several commentators have suggested that the Fed may be delaying a necessary cut in interest rates. The story goes something like this; recent data tells us that economy is slowing rapidly, whilst inflationary pressure is subsiding, and if the Fed doesn't do something soon, then the economy will slip into a nasty recession by the end of the year.

The problem at the story is that it's only half true. Certainly, the economy is slowing, but inflationary pressures remain rather strong. Just take a look at gas prices if you own any doubt about that. The consumer still keeps on consuming, as the chart above suggests. There is a slight post-holiday dip consumption,but by March everything is back to normal. Certainly, the housing market is looking into the abyss, but the stock market is doing fine, so the overall effect on wealth is redistributive, rather than a growth reducing.

However, if you think about a little further, you will realise that it is consumer spending that is the problem, not inflation. There is a nasty story behind that retail sales chart. It is a story of declining personal savings. Low interest rates have discouraged savings, and encouraged consumption, which in turn has been fuelled by an accumulation of private-sector debt. The counterpart of this declining savings rate is found in the US current account. The federal government has also done its part to accumulate a large stock of debt. For several years, the government has run large fiscal deficits, financed by treasury bills, largely bought by foreigners.

Private and public sector balance sheets need to recover, which is just a fancy way of saying that people need to save more and the government should reduce spending. The only thing that will make people save more is a higher return on their savings. This is why the Fed needs to raise rates, and at a minimum, keep them at the current level for the foreseeable future.

What would happen if the Fed decided to cut rates prematurely as some would suggest? Simply, the consumer would keep on doing what she has done the last five or six years. She would keep on borrowing, keep on spending, and keep on building up debt. The US current account will continue to be high. In the short term, foreign central banks will keep financing that deficit, until one day they will have had enough, and suddenly start selling dollars. At this point, the current account will adjust very rapidly indeed, and the US economy could sink into a calamitous recession.

Currently, the economy is slowing, but that is a good thing. It is better to have a gradual slowdown in growth, coupled with an orderly repair of private balance sheets, rather an a disorderly financial crisis. Let's hope that the Fed ignores these shortsighted calls for a cut in interest rates.