Why the Recovery Looks Like a Keeper


By Christopher Farrell Tradition is reassuring. That's why it comes as something of a relief that the economy and the financial markets are starting to follow the script of previous rebounds. Hopeful investors drove stock prices higher in March and April despite dismal economic numbers, to the dismay of head-wagging bears. But the optimists were right, and the economy is springing to life with gross domestic product surging ahead at a 7.2% annual rate in the third quarter. The job market typically bottoms out about five to seven months after the stock market turns up, and anecdotal evidence -- as well as September's payroll gain -- suggests management is hiring again.

The Federal Reserve may have kept its monetary policy unchanged at the Oct. 28 Federal Open Market Committee policymaking meeting (see BW Online, 10/29/03, "The Fed Sticks to Its Story"), but stock-market gains are slowing while investors begin adjusting to an inevitable rise in bond yields as the economy accelerates. "Many are now beginning to accept that this may finally be the 'real deal' recovery," says James W. Paulson, chief investment strategist at Wells Capital Management. "The primary consensus question is shifting from 'When will we recover?' to 'How strong and how long will this recovery be?'"

GLOOM AND DOOM. Perhaps, but it can also be helpful to think about what could go wrong. It's easy to spin out any number of disastrous twists and turns, but the risk with some credibility is the one haunting the currency markets. The American dollar is down anywhere from 15% to 25% (depending on the benchmark) over the past 18 months.

The decline hasn't roiled the global financial markets so far, since much of the drop reflects market forces. And the downward adjustment has offered relief to the nation's beleaguered manufacturing sector. A weaker dollar improves the competitiveness of U.S. companies that export goods and services.

Currency traders worry, though, that the Administration's implicit weak-dollar policy will become more explicit during the 2004 election year to curry favor in the main manufacturing states. A lower dollar eventually translates -- in the minds of investors and speculators -- into the notion that the Administration wouldn't mind a bit of inflation. If fears that inflation is about to be unleashed gained widespread favor, the dollar's value likely would plunge, panicking America's equity, bond, credit, and capital markets (see BW Online, 10/20/03, "Time to Fret about Inflation Again?").

A STALWART FED. The risk is real. Team Bush has sent confused signals, saying one day "Yes, we want a strong dollar," only to suggest another time "No, we wouldn't mind if the dollar went lower." In his latest comment on Oct. 30, before the Senate Banking Committee, Treasury Secretary John Snow testified: "As I have said often, a country cannot devalue itself into prosperity. A strong dollar is in the U.S. national interest." Perhaps he'll say something a bit different next time.

Yet I'm not convinced a dollar crisis will come to pass. The greenback's value should stabilize and improve as economic growth strengthens. Fundamentals will trump rhetoric. What's more, the Fed isn't about to permit any sustained revival in inflation expectations. America's central bank doesn't want to lose its hard-fought two-decade struggle to gain global market credibility on fighting inflation. Alan Greenspan is no Arthur Burns, let alone a G. William Miller. Despite their other accomplishments, to this day both men are associated with the runaway inflation of the '70s, when they each had a stint as Fed chairman.

Yes, technically speaking, Treasury Secretary Snow and his minions are responsible for the dollar in overseas markets. But in reality, the Fed is the guardian of the currency's purchasing power. Over the past decade or so, the dollar has gone from a widely perceived weak currency into the most trusted "brand name" in global finance, the standard confidently used by global lenders and traders to write contracts and exchange products.

HIRING SOON. Like any good business, the Fed is well aware that the price for devaluing a brand name for short-term gain is catastrophic. "Market actors are understandably sensitive to even the slightest sign of recidivism by governments," writes Benjamin Cohen, political scientist at the University of California, Santa Barbara. "A commitment to 'sound' management, therefore, cannot easily be relaxed. States can never let down their guard if they are to establish and maintain a successful brand name for their money. In fact, a deflationary bias is regarded as an imperative of sound management -- simply the price to be paid for defending a currency's reputation."

Maybe Snow fumbled dollar policy in recent months, but his widely ridiculed Pollyannaish prediction that the economy will start creating 200,000 jobs a month is a bet on the safe side. I'm convinced the recent momentum in business investment in high-tech gear, which cratered for much of the past three years, is sustainable. Business is investing in more than maintenance and repair, but for growth and efficiency. The spate of megamergers, such as the $47 billion combination of Bank of America (BAC) and FleetBoston Financial (FBF) and the $16.4 billion deal, also demonstrates that management is coming out of the bunkers.

In fact, I'm betting the recovery will be stronger than expected going into 2004 and that inflation won't emerge as a major problem. And that would really be something to celebrate. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online


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