It seems that Federal Reserve wants to talk up the markets, but the attempt to do so without correction of the imbalances in the economy would cause sub-par growth for a long time.

IF you are one of those who keenly listen to every word that the Federal Reserve Chairman, Alan Greenspan, utters for clues on the direction of the US economy, you have reason to be a bit confused with his latest congressional testimony.

No one can forget the famous speech in May in which the chairman had cautioned on the risk of deflation and the possibility of use of unconventional measures that may be needed to avert deflation.

Financial markets saw this as a clear attempt by the Federal Reserve to flatten the yield curve and bring long-term interest rates down. We saw a huge rally in the Treasuries with the 10-year bond touching a low of 3.07 per cent in June.

In the latest congressional testimony on July 15, Greenspan chose to sound unusually optimistic about the economy and upped the growth projections. More importantly, he brushed aside the deflation risk and need for any unconventional measures.

One casualty of this has been the bond market which saw the most aggressive sell-off in a month in the last ten years.

The 10-year bond touched a high yield of 4.08 per cent. If one looks at the US economic data over this period, it still remains below expectations.

What has prompted such a dramatic turnaround in the view? In this article, we look at what has prompted this optimism and if this makes sense. There are mainly five factors, which seem to have prompted the Chairman's view to change from pessimism to optimism.

One factor, which has been a drag to the economy, has been the balance sheet restructuring, which has forced companies to reduce debt and resources.

An indicator used in the testimony has been the drop in net interest payments to the cash flows of the businesses. This ratio was at a peak of 43 per cent in 2001.

It has now dropped to 35 per cent, but still is way above the level of 20 per cent that it had dropped in earlier recessions.

This ratio looks a tad better if one looks only at non-financial sector. However, one should keep in mind that in the auto and airline industries, companies record most of their debt in the books of their finance or leasing companies and cause this skew.

One reason the cash flow is looking better is also because of higher depreciation as economy has shifted towards high tech from low tech.

High tech capital depreciates quicker. This suggests that the improvement in cash flows may be because of structural reasons rather than net of depreciation or free cash flow improvement.

The second factor is the drop in the ratio of current assets to current liabilities. This is seen as a precursor to a growth rebound as the corporate sector issues long-term debt to reduce short-term debt.

This ratio tends to decline towards 20 per cent before or during a downturn. However, in the recent recession, this ratio has remained high and gave no indication of the downturn to come in 2001.

So the usefulness of this ratio in the current scenario may be a bit suspect.

The testimony also notes the willingness of banks to lend to business community. This assertion is against Fed's own data which shows that the commercial and industrial loans have been on an uninterrupted falling trend in the last few years. Even the Fed's senior loan officer's survey also shows that lenders are becoming `less' tight rather than being willing to lend.

The third factor is that households have taken advantage of low mortgage rates and refinanced their debt on more favorable terms and this has caused debt service burden to fall. If one looks at the Fed's data debt-service burden as a proportion of disposable income, one would note that mortgage rates have dropped to historic rates, but debt service burdens have hardly budged.

This ratio has declined from 14.4 per cent in Q4 of 2001 to 13.99 percent in Q1 of 2003. This ratio is higher than that in early 1990, which was a difficult time for the economy.

The mortgage debt service payments have rapidly increased in recent times as rates decline, indicating that the household sector increased their mortgage debt. The fourth factor is that tax cuts announced by the administration would prompt increase in consumer spending. However here, the Chairman went on to add a caution that the next few weeks would provide a test to the extent that this expansionary fiscal policy works. A look back at the tax cuts in 2001 and 2002, however, indicates that these cuts did not result in pick up of underlying consumption trend and on the other hand resulted in increase in personal savings ratio. In the current environment, wherein the pension schemes have large shortfalls, any tax cuts are again likely to increase the marginal propensity to save. The final cornerstone of the testimony is the recovery in equity markets. The board indices have rallied and Dow Jones Index is up by around 25 per cent for the years. The rally in the equity markets may not hold as the valuations remain rich. The price to earning ratio has dropped from 50 times in 2000 to 27 times earning at the moment. This still looks substantially higher than 20 times earnings that existed in 1996, which has prompted the famous `irrational exuberance' speech. It is unlikely that the Chairman would consider equities cheaper now if they were expensive at that time! It seems that Federal Reserve wants to talk up the markets, but the attempt to do so without correction of the imbalances in the economy would cause sub-par growth for a long time. The risk of a huge disappointment in the second half and an at least another rate cut this year in the Fed funds rate remains high.