Interest rates

Not long ago Mr. Greenspan was pursuing an unusually cheap-money policy to foster stable economic growth . So does this mean that Mr. Greenspan has already achieved his goal?

No, not fully. Unfortunately, his plan has been overtaken by other economic exigencies. High oil prices (over $50 a barrel) are taking a toll on economic activity . The US continues to be the world's number one importer of crude oil. In the United States exports are low, imports are high and entrepreneurs are not investing enough on machinery and equipment. Factory production is falling gradually and has been doing so for the last few months. Actually the overall picture does not look very bright. In the first quarter of 2005 the GDP fell to 3.1 percent from 3.8 percent in the last quarter of 2004, which is the lowest since the second quarter of 2003.

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There are other disturbing signs on the horizon. Low national savings of the United States are probably causing more headaches to economic planners than any other single factor. The national savings figure represents "the amount the Americans save less the amount government borrows". American savings have dropped from about 10 percent of GDP in the early eighties to only about 1 percent today. According to The International Herald Tribune, "If the current rate of borrowing continues, the US will borrow an unprecedented $1 trillion this year alone, mostly from abroad, a sum that is reflected in the huge US budget and trade deficits". Meanwhile, US trade deficit keeps rising in a relentless manner. The strategy behind the low dollar policy, (dollar fell by approximately 25 percent against other major currencies) was to reduce the trade gap by exporting more and importing less. But the latest ( February, 05) figure indicates that the trade deficit reached a record of $61 billion dollars. American exports remained unimpressive, in February only 8.8 percent higher than in the same month in 2004.

Exporters world-wide are engaged in a fierce competition to maintain their share of the export market, specially the American market and for that they are prepared to ride out currency fluctuations even if it means lower profits. Therefore, imports from abroad show no sign of ebbing. In February imports went up by 17 percent over imports in February last year. " The trade deficit is the single most important factor in measuring the extent to which the United States lives beyond its means."

The US economy is caught up in a vicious circle. In order to finance its trade and tax-cut based budget deficits it must borrow from abroad. The more indebted a country is, the higher the price it has to pay to lure the lenders to lend more. It inevitably pushes the interest rates higher. These deficits weaken the dollar against its main rivals, the euro and the yen. On the other hand, higher interest rates have a negative effect on the share and bond prices. A declining dollar also encourages American manufacturers to raise prices thereby creating further inflationary pressure. Higher inflation leads to even lower savings forcing the United States to borrow more from abroad.

No wonder, Mr. Greenspan is more worried about rising inflation, (which now stands at 3.1%) than slow economic growth, which in any case is higher than that of the euro area. Unusually high oil prices over a prolonged period will have a spiral effect on the inflation. Although any future movement in the US interest rate should depend on the evolution of economic activity, employment and the inflation rate, the factor that right now worries the Fed most is the current inflationary pressure, hence the Fed's policy to raise short-term interest rates at a "measured pace". Experts are, however, not sure whether this policy alone will be able resolve all of America's economic problems. They point out that as long as serious measures are not taken to correct the fundamental imbalances of the American economy -- low national savings, profligate spending, huge trade and budget deficits -- Mr. Greenspan will have a hard time in achieving positive results on a sustained basis.

The situation in the euro area is rather different, where poor economic growth is the main concern. Although low dollar has so far eased the pressure of rising oil prices (which are usually quoted in US dollars) on the EU economies , a recent ECB report confirmed that if this phenomenon persists, it will have a negative effect on the economic growth potential, particularly a sustainable one. Besides high oil prices, the strong euro is also biting into the euro area's growth by reducing exports. The IMF has recently cut this year's expected economic growth for the euro area from 2.2 percent to only 1.6 percent. The European Commission has not only not challenged this cut but has even confirmed it. (By the way, this year, Japan will grow only by 0.8%.) According to official sources, manufacturing in the euro area fell for the first time in nearly two years in April, 2005. This trend was further confirmed by Bloomberg. A rise in the interest rate will hurt even this low growth potential.

To stimulate economic growth, there are pressures from Germany and France on the European Central Bank to lower the interest rates even further. Although the Euro area inflation rate remains quite low (1.9%) and the forecast for 2006 is even lower (1.7%), it is highly doubtful that the ECB would agree to lower the interest rates further. It will most probably leave the short-term interest rate as it is as long as the inflation is under control. The ECB is, of course, conscious of the fact that low interest rates are feeding unusually high real estate prices in some member countries, for example in Spain, which does not bode well for a stable growth.