By Norman F. Klopp, Jr., CFA, Partner

The global economies stand at a particularly important balance point. How that balance changes could have significant implications for Federal Reserve policy over the near term. And what is the primary factor influencing that balance? The U.S. trade deficit. Recently, we in the U.S. have been buying in excess of $30 billion more each month from sources abroad than we have been selling there. To put this in perspective, as recently as 1992, the trade deficit for the whole year totaled $36 billion. In the last few months it has exceeded $30 billion per month.

Problems ahead?

During our historic economic expansion, this has not been a serious problem – until now. The availability of goods from abroad reduced pressures on our already tight domestic production capacity. The strong dollar has kept import prices down which in turn helped keep inflation under control. While the U.S. economy has been growing rapidly, international economic growth has been sluggish. This has allowed the Fed to be persistent, but measured, in its successful moves to control domestic inflation.

But, what if the balance changes? If, as some expect, the growth rate of the U.S. economy slows while foreign economic growth accelerates, export demand will accelerate, affecting the Fed’s desired domestic slowdown. This could force the Federal Reserve Board to extend interest rate increases further than it desires, in order to control the U.S. economy. While the trade deficit might narrow, the economic and market risks in the U.S. are extended.



Potential earnings risk

The second possibility would have foreign economies slowing in sync with the expected U.S. slowdown. Global central bank interest rate increases over the last twelve to eighteen months could cause this to happen. This might result in a lower trade deficit as import and export demand declines, but it would also raise the probability of a much “harder” landing for the domestic economy and cause the Fed to appear to have been much too restrictive. The risk to corporate earnings would be most significant.

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“We are not ready to worry, but we are obviously watching closely”!

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Finally, if U.S. growth does not slow and foreign economies accelerate, the trade deficit will probably narrow as export demand increases. The pressures on our capacity will also increase, as will the risk of inflation. This inflation risk becomes even greater as the dollar would likely weaken in this scenario, increasing the costs of imports. Pressures on the Fed and other central bankers to continue to raise rates would significantly increase the probabilities of a “hard” landing.

What are the conclusions? The historically high trade deficit increasingly limits the Fed’s options in the U.S. economy. It also raises the risk of increased global economic volatility after years of an historic, disciplined domestic economic expansion. The key factor, as we see it, is time.

Close watch necessary

No matter how these options develop, if it happens in an orderly fashion over a reasonable length of time, say five years or more, we will have again resolved an economic imbalance in a disciplined fashion. On the other hand, if short-term volatility in interest rates, currency values, capital movement or other factors begin to appear, the risks identified in each of the scenarios above become real. And the risks in the market increase. We are not ready to worry, but we are obviously watching closely!

If you have questions or comments about this report, you may contact Norm Klopp at (216) 830-1135 or e-mail: nfk@mimllc.com

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Perspective is published quarterly by Midwest Investment Management LLC, Cleveland, Ohio for its clients, friends and members of the business community. All information contained herein reflects the opinions of the authors and does not necessarily constitute investment advice. Past results are no guarantee of future performance. ©2000, Midwest Investment Management LLC. All rights reserved.