Fed: To-Do or Not-To-Do

The US Economy has a Cold...So What???

So the million $$ question is ‘What is the Fed going to do?’ Are they going to lower interest rates or keep them steady?? Are they going to sit back and let billions be shaved off or are they going to try and control the financial markets. Anyone who has been watching their investments, the stock market and major indexes must be having a panic attack right about now. As the weather has heated up in the summer, the economy seems to have cooled.

Problems in the credit markets are translating into fears for consumer spending as well as increased worries about housing. All headlines keep talking about subprime and credit fears. So the bigger question is ‘Is there a real reason to be worried??’ If so, when should we start to worry or has that train already passed. Lets see, the 3% growth rate of the past four years has slowed to 1.9% over the last four quarters.

The economic weakness also changes the outlook for interest rates. Both the European Central Bank (ECB) and the Federal Reserve (Fed) have added reserves last week, with the ECB doing most of the work.

So, What’s up with the Housing Market?

Continued declines in home sales show that the housing market is under severe pressure. However, this remains only a mild housing recession by historical standards. It is the first major housing downturn in the U.S. since 1991-1992, so it seems more severe than it is and everyone is pushing the panic button, but one has to remember that real housing recession cycles tend to be dramatic, as major recessions have shown declines of more than 50%. It is indeed interesting that in the 2001 recession, the Federal Reserve's sharp interest rate cuts kept the housing market strong and this time around they are playing the waiting and watching game.

Also, remember that the sharp rise in home prices is a worldwide phenomenon, spurred by low interest rates. As I write this India has started to build million dollar homes in various cities and they are sold out even before a single brick has been laid. To most buyers, the price of a home is essentially the monthly payment, and with U.S. mortgage rates at so low in 2002-2003, Americans could buy a lot of home for only a small monthly payment. But as interest rates rose with the Fed tightening, the monthly payments increased, and homeowners who were selling found that prospective new buyers couldn't pay as much. Some homebuyers dropped out as a result and the homeowners who wanted to sell had to reduce the home prices in order to sell.

Trade Deficit is Shrinking

On the trade front, the deficit has been shrinking slowly since its October 2005 peak of $67.1 billion, to $60.0 billion in May and an average of $59.1 billion for the first five months of 2007. The trade deficit has narrowed in response to three major changes: the fall in the dollar, the weaker U.S. economy, and stronger overseas growth.

The weaker dollar is clearly part of the reason for the improvement. The first impact of a weaker dollar on the deficit comes from higher import and lower export prices, which tend to worsen the deficit in the short term. Only in the longer run do higher export and lower import volumes offset this price effect. The second major change contributing to a smaller trade gap has been the softening of the U.S. economy. As growth slowed to 2% from 3%, demand for imports cooled as well. The third factor is the continued improvement in the world economy, particularly in Asia, Japan and Europe. In 2005, the Eurozone's GDP rose a meager 1.6%; this year, its going to be almost 3%. Similarly, Japanese growth was 1.9% in 2005, and it is 2.3% this year and Asia’s well, I don’t have have to say (considering China and India have been continually posting double digit growth numbers). These figures are especially important because the U.S. exports mostly to the industrial countries, while it imports from non-Japan Asia and the Americas.

Federal Deficit has Fallen

The decline in the federal deficit has been a major surprise to one and all. The gap is expected to be $179 billion in fiscal 2007 (down from $428 billion in fiscal 2002), which is only 1.6% of the U.S. GDP. Strong revenues—not less spending—have narrowed the deficit because government spending rose faster than GDP over the past four years. Spending may slow if there is a decline is military spending (The generals are planning a troop reduction in Iraq as I write this). However, the budget deficit should remain near its current level for the next few years.

State and local governments are healthy, again largely because of strong revenue growth. The aggregate of all state and local budgets have moved back into surplus on an operating basis.

Economy and Inflation

The inflation rate is running at a relatively moderate level. The Fed's preferred measure—the consumer expenditures price index excluding food and energy items—was up only 1.9% from a year earlier in June, which is definitely within the Fed's comfort zone. The Fed remains nervous about inflation (well, they better be as I don’t want to pay 10 bucks for a gallon of milk). One worry, however, is that the downward revision to real GDP growth in the most recent data implies that productivity growth has been running about 0.25 percentage points lower than previous projections, which would reduce the estimated trend growth for the economy to about 3% from the 3.25%. This would also unfortunately revise costs higher, suggesting more inflationary pressure.

The spread between U.S. and European bond yields has narrowed too much and seems too low to attract the funds needed to finance the U.S. trade gap. So I think we can safely say that our German and British friends are not going to be buying US bonds anytime soon. The 10-year U.S. Treasury note is yielding only 0.46 percentage points more than the equivalent Euro bonds, which is less than half of last year's spread. U.S. yields are likely to rise in response to the higher European yields, even if the Fed begins to cut short-term rates early next year.

The economic expansion has slowed, which should not be a surprise after 17 consecutive Fed rate hikes. The growth remains solidly positive, resembling the 1995-1996 period, when real GDP fell back to 2% for a year and then reaccelerated. So far, the slowdown is mostly confined to the housing market, with the consumer continuing to spend confidently. However, the risk remains that higher oil prices or a sharper rise in bond yields, which could in turn further damage the housing market, might still turn lower growth into a recession.

The Stock Market

So the global markets have been falling for the last one week (falling steeply at that). So what is happening to the stock markets?? Is there reason to panic? Well, in 2 simple words: ‘Market Correction’. So much EZ credit was created that people invested like there was no tomorrow and drove up the stock prices to insane levels and

market correct had to happen at some point. Thanks to private equity, billions have been poured into the markets artificially inflating securities. And now with the credit cycle tightening and hedge funds reporting losses, people are starting to pull back. One must remember that all this selling is purely driven by technical factors at this point, because the fundamentals of the market are good. Once a person panics, I doubt if he will be think about the beta of the stock or the EPS or growth potential. But in a way, it’s a good thing that the markets are correcting as it brings back a lot of sanity without the Fed getting involved.

However, global economic fundamentals are strong with real growth happening in Europe and Asia and they continue/will continue to provide a solid base for financial markets to adjust. The overall US economy and the markets are strong enough to absorb this correction.

Verdict: So What Should The Fed Do?

The considerations for the Fed are changing by the day. The disorder in financial markets has caused both the Fed and the ECB to inject liquidity into the system. Regardless of issues of the economy and inflation, the first priority of a central bank is to maintain orderly financial markets. Without orderly markets, the central bank has no direct or indirect control over the economy in any event.

Except for housing, the economy is still expanding by more than 3% annually. But over the last four quarters, there has no doubt been a drop in construction activity which could be the reason GDP has lowered. In all probability, housing will continue to depress growth into early 2008 (especially as the ARM’s reset going in the 2H 07 and 2008). However, the longer term outlook remains solid, with GDP growth likely to return to near its 3% trend by the second half of next year. The economic data continue to show slower U.S. GDP growth. However, the weakness remains isolated in the housing market.

But with the continuing housing problems and sluggish economic growth, the fed is unlikely to tighten this year. On one hand, inflation is still a concern, and on the other hand, labor markets are still tight. In all probability, the Fed is likely to do nothing in the near term with regards to interest rates; Remember that a rate cut will further weaken the dollar and make the treasuries less attractive to foreign buyers. (I doubt if the US can afford to do that at this point). I do, however, anticipate a cut early next year once all the credit and Subprime issues are out on the table and the picture gets a lot clearer. As of now, no one knows how much exposure the various financial institutions have with regards to Subprime (also esp. since it is believed there is a lot of exposure to hedge funds, which are not required to report anything) and additionally the methods to value these securities have come into question (No one is sure what the exact ‘Mark to Market’ values of these securities actually are).

Once the rates are cut, people will start to get more credit and housing will improve, everyone will start buying stocks; people will forget their worries and a whole new economic cycle will begin.

What is Islamic Finance?

After more than three decades of modern Islamic finance and banking , the world is seeing double-digit growth rates for Sharia-compliant assets. Islamic finance and Banking is currently being expanded beyond its historical borders of the Gulf region, where it began to emerge domestically in the 1970s as a result of the oil boom. This has driven Islamic financiers to look beyond historical boundaries to explore new territories, both within and outside the Arab world. It has finally emerged in many parts of the world as an alternative financing concept to the conventional orthodoxy of paying interest on borrowings and deposits.

An investing approach based on "Sharia" or Islamic law, Islamic finance has begun to spread all over the world. Modern Islamic financing techniques were developed in Muslim parts of Asia, notably Malaysia, but the boom since the mid-1990s has come from the large oil revenues flowing into the Gulf region. Now, the ideas and concepts of Islamic finance are attracting conventional issuers and investors seeking to tap into new investment opportunities.

What are the key principles of Islamic finance?
To be considered Sharia-compliant, a financial institution or transaction needs to meet the Koran's strict tenets against usury and uncertainty. The most important principle of Islamic finance is "riba," the ban on charging or paying interest. Sharia (set of guidelines as per the Quaran) doesn't consider money as an asset class because it is not tangible; therefore, it may not earn a return. Instead, Islamic law calls for a means of sharing the profits from a transaction or institution among participants - here, the client and financial institution or instrument. Secondly, Islamic law prohibits uncertainty of payout or gambling, but not risk as long as it is shared among all parties. No one participant should shoulder an unequal degree of risk. Thirdly, any Sharia-compliant transaction must be backed by a tangible and identifiable asset. Lastly, Islamic finance forbids investment in or dealings with those industries banned under the Koran: notably alcohol and brewing, tobacco, weapons and armaments, or pork-based products.

How are Islamic banks different from conventional banks?
The biggest difference between Islamic and conventional banks is that Sharia-compliant institutions do not pay interest on deposit accounts. The attraction for clients, however, is that Islamic banks usually also offer profit-sharing investment accounts (PSIAs) that are bound by a "mudaraba" contract. These PSIAs are a major source of funding for Islamic banks.

The Rising Rupee: Boon or Bane?

Rising Rupee

The rupee has been rising against the dollar for the last couple of months. But what has sent the alarm bells ringing is the speed with which the currency has risen (nearly 10% against the $$ in the last 6 months). Though everyone keeps talking only about the dollar, it is interesting to note that the Rupee has, in fact, also steadily risen against other currencies in the last 5-6 months (8% against the pound, 7% against the Euro and 11% against the yen).

Is this a problem or is this really good for the Indian economy?? One thing is for sure. This is a drastic departure from past policies and a strong rupee will have a really big impact on the Indian economy. The main reason for rupee's appreciation in the last 6 months has been the flood of foreign investments and remittances into India (esp. US$). These $ inflows are coming in the form of foreign direct investment (FDI) to remittances sent home by Indian expatriates. In each case, the flow seems unlikely to slow down anytime soon. That coupled with the Indian stock market's stellar performance has the foreign portfolio inflows booming. The large and steadily increasing net inflow of foreign exchange into India has translated into an excess demand for rupees. Like any other good or service, the excess demand for rupees has resulted in an increase in the price of the rupee.

The rupee's appreciation is alarming exporters, as it makes their products more expensive in overseas markets and erodes their international competitiveness. The software exporters for one are already starting to miss their earnings. The last month has seen all major software exporters taking a hit and there is already evidence in India of an export downturn in a number of other sub-sectors as well (Textiles and Commodities). This is mainly because Indian exporters earn their revenues in foreign exchange. So the more and more the rupee appreciates, the less and less they earn. The current situation has all the exporters screaming as the profit margins are being squeezed out. In a way this is like the shortest growth story as just when the Indian export industry is being talked about as a great economic engine, it looks like the exporters are already being forced to shut shop as they are unable to compete and losing out to their biggest rival, China.

An important factor in the central bank's policy change in allowing a stronger rupee is the rising inflation. The RBI typically controls the appreciation by manipulating demand-supply dynamics of currency market. In order to prevent the rupee’s rise, RBI bought close to $20 billion in the last four months to curb the rupee’s rise (Incidentally, India's foreign exchange reserves have now crossed the $200-billion mark). But as RBI purchased dollars (creating more demand for dollar) and sold rupees (increasing supply of INR, thereby decreasing its value), the money supply increased - which meant too much money chasing the same (or less) number of goods – and this led to increased inflation in the country. The increased liquidity therefore fuelled inflation and of course as we all know this comes with a 'Political Cost' attached to it. So the RBI backed off and let the rupee appreciate again. When RBI was buying billions of $$, inflation shot up in excess of 6%, but when they stopped buying $$$, the resulting large drop in money and credit growth lowered inflation significantly - The govt. has targeted a 5% inflation for 2007.

Of course on the flip side, all the importers are extremely happy as imports have become much more affordable. An appreciation of the rupee has made the import of foreign goods (such as crude oil and petroleum products) cheaper (in rupees) in India. The rupee appreciation should exert a downward pressure on the inflation rate. A strong rupee in nearly a decade may be good news for importers and those who see the currency as a symbol of economic prowess. However this does little to prevent the dilution of our country's competitiveness because a cheaper dollar makes imports easier and exports tougher. The profitability of exports is already being affected, and if the appreciation in the rupee continues unabated, they will feel the pinch and exports will suffer.

So is a strong rupee really curbing inflation?? Should RBI buy more $$ to curb the Rupee?? RBI has a difficult policy choice at hand. In which direction it will move will depend on which objective is given more important i.e inflation control, maintaining export growth or capital account convertibility. The government and RBI are keeping their fingers crossed and hoping that there will be no need for a major intervention. However, given the amount of $$ flowing into India the problem is unlikely to disappear soon.