Friday’s GDP report did little more than confirm the uncertainties in the economic environment that the markets have been grappling with since late summer. Overall, the economy slowed in the third quarter, but not by nearly as much as the 2.7% headline number would suggest. Much of the reported slowdown from the second quarter’s 5.6% growth rate can actually be explained by the large contribution to growth made by inventory investment and government spending in the earlier quarter. Inventory additions in the third quarter, for example, remained at second quarter levels of nearly $80 billion annualized. But because the rate of inventory buildup didn’t rise much from those already high levels, it made only a marginal contribution to third quarter “growth” after accounting for 1.7% of the second quarter rate. Adjusting for the ebb and flow of the data for inventories and government expenditures from one quarter to the next, the economy looked to be maintaining underlying expansion at a pace of about 4% across the two quarters.     

Nor did the GDP data support widespread fears of a downturn in the information technology sector, as investment in information processing equipment and software maintained growth at a rate of nearly 20% in the quarter. U.S. enterprises have as yet evinced few signs of retreat from the drive to transform the capital stock by capturing the productivity gains made available through the revolution in technological innovation. That was reinforced by the September durable goods report, also released Friday, which showed new orders for electronics and electrical equipment surging by nearly 12% for the month. Durable goods orders can show great month-to-month volatility, but on a 12-month moving average basis, electronics orders are up about 18%.

Nevertheless, there also are unmistakable indications that the Fed’s ill-considered campaign to restrain growth is reducing expected returns to capital and increasingly feeding a deflationary scarcity of dollar liquidity. Notwithstanding the sustained robust rise of the “New Economy” sectors, overall growth of business fixed investment slowed sharply in the quarter, to a rate of 6.9% compared with the second quarter’s 14.6%. This suggests that while adoption of the IT upgrade is still considered a competitive necessity, a too- tight Fed has raised the cost of capital to levels constraining marginal investment activity. In the last three months, for example, new orders for non-defense capital goods, excluding aircraft, have fallen nearly 5%, after rising at a rate of better than 8.5% the previous quarter. It’s unlikely that even the highest-priority technology investments can withstand these pressures indefinitely.

If analysis of the aggregate data presents a mixed view of current economic performance, more forward-looking monetary indicators are cause for considerable concern. With the price of gold breaking below $265 per ounce, nearly $20 below its one-year moving average, and the dollar’s foreign-exchange value continuing its seemingly inexorable rise, there is not much question that the Fed’s deflation-biased stance poses a growing risk to domestic and global commerce. Regression analysis reveals that fully 75% of the dollar’s gains since early July can be explained by the strengthening in purchasing power indicated by the falling dollar gold price. For the most part, weakness in foreign currencies simply reflects this real dollar appreciation.

Trade-Weighted Dollar Index versus Gold

There are, indeed, some eerie parallels between current conditions and those which presaged the fall-1998 deflation-induced financial panic. Junk bond spreads – at nearly 800 basis points -- are back near the highs recorded in October 1998; commodity prices – excluding oil – are falling; and key emerging-market currencies – including the Thai baht, Chilean peso and Brazilian real -- are under considerable pressure. One tell-tale sign of the stress imparted on world markets by the dollar’s appreciation can be seen in the recent liquidation of the Fed’s custody holdings of Treasuries for foreign central banks. Since late August, the Fed’s portfolio of foreign official holdings has shrunk by some $30 billion, an indication of the pressure on central banks to meet the demand for scarce dollars against their domestic currencies. At less than $590 billion, the Fed’s custody holdings of Treasuries for foreign accounts have sunk to levels last seen during the late-1998 recovery from the financial crisis, after peaking at $640 billion in early April this year.

It probably would be a mistake, though, to assume that the Fed will again threaten collapse of the global financial system before responding to these signs of distress. Our reading of Fed Chairman Alan Greenspan’s recent speech to the Cato Institute is that he is laying the groundwork for a fairly early shift to an easing mode once oil prices begin to recede toward equilibrium levels (“A Bullish Treasury Outlook,” October 24, 2000). The bulging risk premia that have been priced into a broad spectrum of dollar-denominated assets should by then present an array of attractive buying opportunities.