Fed Rate Hike, Strong Dollar Create Headwinds For US Economy: Koo

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Nomura Chief Economist Richard Koo says the QE worm is turning and the U.S. economy is likely to face the dual headwinds of a Fed rate hike and a strong dollar for some time.

Koo argues that the looming Fed rate hike is a major overhang on the U.S. economy on several levels. He explains: “…the phenomena currently unfolding in the US and elsewhere are signs of a reverse portfolio rebalancing effect triggered by the Fed’s decision to normalize monetary policy.”

U.S. economy clearly not revving up yet, Fed rate hike looming

Koo highlights that while U.S. manufacturers continue to suffer from the strong dollar, and their complaints are being heard in Washington, there is really little that can be done at this point.

He notes that slowing economies abroad are hurting U.S. exporters when they were already dealing with pricing pressures from a rising currency. The strong dollar is also exacting a major toll on the U.S. tourism industry.

Another thing to keep in mind is that a big chunk of American capital investment had come from shale gas and other energy-related sectors for several years, and that capex has dropped to a fraction of what it was three years ago. This is having a catastrophic impact on U.S. manufacturers providing equipment to these sectors, many of whom had recently geared up for higher production.

Koo describes the current U.S. economic situation: “All in all, therefore, we have a mixed picture in which domestic economic activity is returning to normal as private-sector balance sheets are gradually repaired, while sectors vulnerable to exchange rates, oil prices, and other aspects of global markets are confronting increasingly tough conditions.”

QE created “wealth effect” in EM currencies and commodity prices

Koo points out that given the private sectors in nearly all developed economies are recording financial surpluses “means financial institutions can lend only to their own governments, the last borrower standing, or to emerging economies.”

He goes on to argue that this is what led to the spike in government bond prices together with large capital outflows from the developed to the emerging economies, and in turn boosted EM currencies. By the same token, cash supplied by central banks also moved into stocks and commodities around the world, sending prices higher.

Ex-Fed Chair Ben Bernanke coined the term “portfolio rebalancing effect” for the process by which the wealth effect from higher asset prices stimulates the economy. That said, it is  important to keep in mind that this increase in asset prices did not really reflect improvements in the real economy. Koo says it was a purely “financial phenomenon fueled by funds that had nowhere else to go in a balance sheet recession, when traditional borrowers are missing in action.”

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