US market turmoil shows constraints on growth

By John Ross Source:Global Times Published: 2018/2/12 22:23:41

Illustration: Luo Xuan/GT



 

Earlier this month, turmoil that had been building for some time, shook US financial markets.

The driving force was the continuing sharp rise in US Treasury bond yields, i.e. the interest rate on US Treasuries, which has risen from 1.86 percent when US President Donald Trump was elected in November 2016 to 2.84 percent.  US Treasury rates set the floor for all long-term US interest rates and are far more important for US economic trends than shifts in Federal Reserve interest rates. This sharp rise in US long-term interest rates will therefore have a slowing effect on the US economy.

Simultaneously US employment data was released showing that wages in January had risen by 2.9 percent from a year earlier. These figures were seen as an indicator of inflationary pressure in the US.

Meanwhile commodity prices, as measured by the S&P GSCI index, had risen by 10.6 percent compared with a year earlier, adding to inflationary pressures in the US.

This combination precipitated a 2.1 percent fall on February 2 in the S&P500, followed by a 4.1% fall on 5 February, the most severe daily declines in share prices since Trump was elected.

To summarize these developments, the US economy was showing signs of rising interest rates combined with rising inflation, which produced the market turmoil. But it is important to understand that these trends are not separate but interlinked. They show that although US economic growth is low by historical standards, with only 2.5 percent year-on-year GDP expansion in the year to the fourth quarter of 2017, the US is showing signs of overheating.

More precisely: First, since interest rates are the price of capital, the sharp rise in US interest rates shows that the supply of capital in the US is significantly smaller than the demand for it.

Second, inflation shows that the supply of goods and services, including labor, is smaller than the demand for it.

In summary, despite low growth, the US is showing signs of capacity constraints.

"I used to think if there was reincarnation, I wanted to come back as the president or the pope … But now I want to come back as the bond market. You can intimidate everybody." This statement by James Carville, adviser to former US president Bill Clinton, accurately summarized the power of the US Treasury bond market. The largest and most secure market for financial securities in the world, the US Treasury market sets the floor for interest rates across the globe.

Interest rates, however, are simply the price of capital. The very sharp rise in US Treasury yields from 1.86 percent on the day Trump was elected president to 2.84 percent on Thursday, is a 52 percent relative rise. It therefore indicates that the supply of capital in the US is falling significantly behind demand.

Simultaneously, and interacting with, the rise in US interest rates, there were clear signs of a rise in US inflation. The US employment report on February 2, showing a 2.9 percent year-on-year rise in US wages, indicated increasing wage inflation in the US. Simultaneously, international commodity prices were rising significantly in US dollar terms - this being accelerated by the depreciation of the currency's exchange rate that has taken place in the past year.  These commodity price increases will feed through into US inflation.

This combination of rising interest rates and rising inflation clearly shows capacity constraints in the US economy and therefore has major implications both for US financial markets and US economic growth.

In summary, despite US year-on-year GDP growth being low, with 2.5 percent growth in the year to the fourth quarter of 2017 compared with 4.4 percent at the peak of the previous business cycle, the US economy was showing signs of capacity constraints and overheating.

It was the effects of this situation that created the turbulence on US markets on February 2 and in the days leading to it.

The root of these symptoms of capacity constraints in the US economy, even at an historically low level of growth, is the low level of US net fixed investment and therefore the slow expansion of the US capital stock.

It is therefore clear that these events on US financial markets have great significance in a double sense: First, from the viewpoint of immediate market operations they show the impact of constraints on US economic growth. Second, from the viewpoint of macroeconomics, these events in US financial markets show the severe constraints that exist for US medium- to long-term economic growth.

Events on financial markets are more volatile than macroeconomic trends. The turbulence on US financial markets will not necessarily lead in any linear sense to a severe financial crisis but it is a clear indicator of the constraints that prevent any substantial acceleration of US growth in the medium to long term.

The author is a senior fellow with the Chongyang Institute for Financial Studies at Renmin University of China. bizopinion@globaltimes.com.cn



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