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Friday, January 07, 2005

Game over?

No doubt, Stephen Roach will backtrack and issue an apologetic editorial in a day or so, complete with effusive praise for Bushonomics.

For today, however, his outlook is grim --- not quite as bad as his pronouncement of economic armageddon --- but not great.

Read --- then cut up the credit cards and invest in seeds.

Global: Game Over?

Stephen Roach (New York)

The unraveling of the Asset Economy could well be at hand. America's Federal Reserve has finally woken up to the perils of the risk culture that its reckless accommodation has spawned. The Fed has sounded simultaneous alarms on two fronts -- inflation and excesses in asset markets. Such explicit warnings from the US monetary authority are rare and should be taken seriously. This has important implications for the interest rate outlook, as well as for the asset-dependent US economy.

As many have already noted, the recently-released minutes of the December 14, 2004 Federal Reserve policy meeting were an eye-opener. The tone of the discussion was far more important than the policy action itself -- a fifth 25 basis point rate hike in the past five months. While the stilted language of the policy action, itself, made reference to balanced risks with respect to growth and inflation, the debate was laced with a very different distribution of concerns. The Fed made special note of inflation risks, citing recent weakness in the dollar, still-elevated oil prices, a cyclical slowing of productivity, and signs of deteriorating inflationary implications signaled in the TIPS market. At the same time, the Fed's newfound concerns over excessive risk taking focused on unusually narrow credit spreads, a notable pick-up in corporate finance activity (both IPOs and M&A deals), and what the policy minutes referred to as anecdotal reports of excess speculation in residential property markets. Better late than never, I guess.

Rarely does the US central bank cast aside the rhetorical shackles of Fedspeak and express its concerns with such candor and fervor. Two earlier instances in the recent past stand out as intriguing precedents -- late 1993 and early 2000 ...

In the second half of 1993, the Fed warned repeatedly of excess speculation in the bond market and the coming normalization of monetary policy. Market participants all but ignored the warnings until the Fed finally delivered in the form of a 300 bp rate hike over a 12-month time-frame beginning in February 1994. The result was the worst year of performance in modern bond market history. A similar, albeit belated, warning was sounded in early 2000, when the stock market was still bubbling to excess. At the time, the Fed couched its concerns in a framework that worried about potential imbalances between the excesses in demand and the growth in potential supply. But the 100 bp of monetary tightening in the first half of 2000 was more than enough for the equity bubble and the excess demand growth it spawned. In my view, the minutes of the December 2004 FOMC meeting follow these earlier precedents quite closely -- especially that of 1993-94. The Federal Reserve is sending a clear warning to speculators that should not be ignored.

And yet, as was precisely the case in the immediate aftermath of the two earlier warnings, an ominous persistence of denial is evident today. Financial markets have barely flinched in response to this sea-change in Fed risk assessment. Yields on 10-year Treasuries are up only about 7 basis points. Moreover, the bubble in risk products remains very much intact: While emerging market-debt spreads have widened by 9 bps, they remain extraordinarily tight by historical standards; the same can be said for investment-grade corporate spreads, which haven't budged at an unusually low 94 bps; moreover, spreads on already tight high-yield debt have actually narrowed a bit in the immediate aftermath of the release of the FOMC minutes. A similar pattern is evident for bank credit spreads and equity market volatility -- a persistence of minimal risk aversion. And the real estate market remains red-hot, riding a national home-price inflation wave that hit 13% y-o-y in 3Q04, with double-digit appreciation in 25 states plus the District of Columbia.

As always, it takes more than words to crack investor denial -- especially with return-starved fund managers seeking refuge in the ever-present carry-trades on riskier assets. The Fed has attempted to be disciplined (e.g. measured) in its tightening efforts thus far. But that approach -- as was the case in the early stages of its 1994 normalization campaign -- has done little to alter the risk appetite of investors and the Fed's perception of inflation risks. Such a response leaves the central bank with little choice other than to up the ante on its tightening strategy. That's what it will take to cope with looming inflationary pressures. And that's what it will take to challenge the economics of the carry trade. Today's Fed -- which has kept the real federal funds rate in negative territory for longer than at any point since the late 1970s -- is wildly behind the risk curve, in my view. Only after the 25 bp tightening of last December did the nominal funds rate match the core CPI inflation rate of 2.2%. For a central bank that has suddenly gotten religion in its concerns over inflation and speculative activity, there's something very reckless about zero real short-term interest rates. Monetary policy must now move decisively into the restrictive zone if the Fed is serious about its newfound concerns. In my view, that could spell as much as another 200 bp of monetary tightening, requiring much larger incremental moves than the measured dosage of 25 bp per pop that has been applied so far.

The big question in all this is whether the Fed is tough enough to face up to the task at hand. Unfortunately, that's a close call -- a sad comment on America's so-called independent central bank. In large part, that's because the US monetary authority is very much a part of the problem that it is now trying to address. By condoning the excesses of the equity bubble in the late 1990s, the Fed set the stage for the near-brush with deflation that was to follow in the post-bubble shakeout. The Fed fought the valiant fight during this period by slashing its policy rate by 550 bps to a 46-year low of 1%. But that then gave rise to the climate of costless short-term financing -- a degree of extreme monetary accommodation that has sparked the very concerns over inflation and speculation that made news in the December FOMC minutes. Unfortunately, this is all emblematic of the biggest shortcoming of modern-day central banking -- an inability to cope with asset bubbles. The Fed has put itself into a tough corner from which there is no easy exit.

Assuming that the Fed sticks to its guns, all this spells tough times ahead for the asset-dependent US economy. That's especially the case for the income-short, saving-depleted American consumer. Lacking in wage-income-generated purchasing power, US households have relied on a combination of aggressive tax cuts and equity extraction from now-overvalued homes to support their open-ended profligacy. Both of those sources of support seem destined to dry up. The odds of any additional near-term fiscal stimulus are low, with the odds suggesting that the thrust of budgetary policy could, in fact, swing the other way. And a sharp increase in US interest rates spells game over for a now-over-extended US housing market and a related drying up of the equity extraction from this asset class -- a wealth effect that has played such an important role in powering the US consumption dynamic in recent years. All this points to a diminished growth impetus from US personal consumption expenditures -- an outcome that should lead to slower GDP growth in the US and weaker external demand conditions faced by America's trading partners. There is a silver lining to such a scenario -- a reduced growth rate of US domestic demand, which should be helpful in providing some relief to America's current-account dilemma. And America's saving-rich trading partners will be hit with the combined impacts of stronger currencies and reduced demand for exports by US consumers -- impacts that could leave countries in Asia and Europe with little choice other than to implement pro-consumption strategies. In other words, Fed-induced pressures on the Asset Economy could well be an important catalyst for global rebalancing.

Many believe that the Fed would be over-reaching its mandate by squeezing carry trades. I don't share that view. Unlike many central banks, America's Federal Reserve is not a one-dimensional inflation targeter. Instead, it is charged by the US Congress with promoting price stability, full employment, and sustained economic growth. To the extent that speculative excesses jeopardize the stability of the US economy, the Fed is well within its purview of addressing financial market imbalances. It did so in 1994 and belatedly again in 2000. Given the current state of excess in the US economy -- the saving shortfall, debt overhang, and twin deficits -- in conjunction with mounting excesses in asset markets -- property and fixed income markets, alike -- aggressive Fed action is entirely appropriate, in my view. Investors won't love the outcome, especially high-yield borrowers at home and abroad (i.e., emerging markets). But this was always the ultimate pitfall of the post-bubble shakeout. The Asset Economy has gone to excess, and it is high time to face the endgame before it's too late. The Fed deserves credit for finally bringing these critical concerns to a head.


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