Friday, March 25, 2005

The Test

Stephen Roach (from Hong Kong)

The US Federal Reserve is behind the curve and scrambling to catch up. Inflation risks seem to be mounting at precisely the moment when America’s current-account deficit is out of control. Higher real interest rates are the only answer for these twin macro problems. For an unbalanced world that has become a levered play on low real interest rates, the long-awaited test could finally be at hand.

In an era of fiscal profligacy, real interest rates are the only effective control lever of macro management. It is important to stress the “real” dimension of this construct -- the need to strip out the money illusion associated with fluctuations in the price level and focus on inflation-adjusted interest rates. From that simple vantage point, America’s central bank is swimming upstream. Measured tightening is being largely offset by a measured increase in underlying inflation -- muting the impacts of the Federal Reserve’s efforts to turn the monetary screws. And it’s become a real footrace: The Fed tightened by 25 basis points on March 22, only to find that a day later the annualized core Consumer Price Index accelerated by 10 bp. In fact, the acceleration of the core CPI from its early 2004 low of 1.1% y-o-y to 2.4% in February 2005 has offset fully 74% of the 175 bp increase in the nominal federal funds rate that has occurred during the current nine-month tightening campaign. At the same time, America’s current account deficit went from 5.1% of GDP in early 2004 to a record 6.3% by the end of the year -- a deterioration that begs for both higher US real interest rates and a further weakening of the dollar. The response on both counts has paled in comparison to what might be expected in a normal current-account adjustment. Behind the curve? You bet.

But how far behind? The answer to that question, of course, hinges on one of the slipperiest concepts in economics: the “neutral” policy rate. This is the magic threshold at which monetary policy is judged to be perfect -- neither accommodative nor restrictive insofar as its impact on inflation or the real economy is concerned. The problem with neutrality is that it is only a theoretical notion -- we honestly don’t know the actual number. In that respect, it’s just like “potential GDP growth” or the “non-accelerating inflation rate of unemployment (NAIRU)” -- equally brilliant macro constructs that are literally impossible to measure. Such is the sad irony of macro policy management: The key metrics we need to steer the economy are not posted in the engine room. In their rare candid moments, the authorities will confess that this is a very touchy-feely process -- you’ll know neutrality when you get there. That hardly instills much confidence in the “science” of macro policy. But I guess that’s why we pay the fiscal and monetary authorities the big bucks.

So let’s venture an educated guess: Say, for purposes of argument, that the neutral real federal funds rate is 2%. I didn’t pluck that number out of thin air: It’s approximately equal to the 1.9% long-term average of the inflation-adjusted policy rate since 1960. It makes some sense -- albeit far from perfect sense -- to define this metric as the average short-term real interest rate that, by definition, would be consistent with average outcomes for growth and inflation. But there’s now a problem: Neutrality no longer cuts it for a Fed that is behind the curve with respect to the twin concerns of inflation and current-account financing. Having played it cute and waited too long, the Fed must now aim for a “restrictive” target in excess of 2%. Again, for expositional purposes, put this level at 3%. Then add in some upside to the core CPI of about 2.75% and, presto, the Fed needs to be shooting for a nominal funds target of around 5.75% -- or more than double the current reading. That amounts to another 300 bp of tightening. If the Fed stays with its measured approach of doling out the tightening in 25 bp installments, then it would finally hit that target 18 months from now in September 2006. Unfortunately, given the long and variable lags of the impacts of monetary policy, the twin genies of inflation and the current-account adjustment might be well out of the bottle by then. If that were the case, the 3% target on the real funds rate would translate into something higher than 5.75% in nominal terms. Little wonder that talk is now rampant of stepping up the pace of tightening. Remember 1994?

These are operational considerations. If you disagree with some of my assumptions, plug in your own metrics on neutrality or the future path of the core CPI. But I would venture to guess that the answer in all but the most heroic cases would still produce a nominal target for the policy rate that is well above the current 2.75% reading. And that sets the stage for the real test: the sensitivity of the US economy and a US-centric global economy to higher real interest rates.

From my perspective, this is where the rubber meets the road for the Asset Economy. Lacking in support from labor income generation, America’s high-consumption economy has turned to asset markets as never before to sustain both spending and saving. And yet asset markets and the wealth creation they foster have long been balanced on the head of the pin of extraordinarily low real interest rates. The Fed is the architect of this New Economy, and most other central banks -- especially those in Japan and China -- have gone along for the ride. Lacking in domestic demand, Asia’s externally led economies know full well what’s at stake if the asset-dependent American consumer ever caves. And so they recycle their massive build-up of foreign exchange reserves into dollar-denominated assets, thereby subsidizing US rates, propping up asset markets, and keeping the magic alive for the overextended American consumer.

Asset markets around the world are now quivering at just the hint of an unwinding of this house of cards. And they quiver with the real federal funds rate barely above zero. What happens to these markets and to an asset-dependent US economy should the Fed actually complete its nasty task of taking its policy rate into the restrictive zone? It wouldn’t be at all pretty, in my view. The main reason is that the Fed and its reckless monetary accommodation have fueled multiple carry trades for all too long. And those trades are now starting to unwind, as spreads widen in investment-grade corporates, high-yield bonds, and emerging-market debt (see Joachim Fels’ March 23 dispatch, “The Party’s Over”). Can an ever-frothy US housing market be too far behind? The optimists tell me not to worry -- that the real side of the US economy barely skipped a beat in the face of wrenching unwinding of carry trades in 1994. That’s apples and oranges, in my view. America was much more of a normal economy in 1994 -- with a personal saving rate of 4.8%. It had yet to experience the joys of consuming and saving out of assets. The equity bubble of the late 1990s and the property bubble of the early 2000s -- both outgrowths of extraordinary monetary accommodation, in my view -- changed everything. Now it is a very different animal -- the Asset Economy -- that must come to grips with monetary tightening.

Largely for that reason, I still don’t think America’s central bank is up to the task at hand. In the face of disruptive markets or growth disappointments, this Fed has repeatedly opted to err on the side of accommodation. I suspect that deep in its heart, the Federal Reserve knows what’s at stake for the US -- and for the world -- if the asset-dependent American consumer were to throw in the towel. Unfortunately, that takes us to the ultimate trap of global rebalancing -- a realignment of the world that requires both higher US real interest rates and a weaker dollar. Should the Fed fail to deliver on the interest rate front, I believe that the US current-account correction would then be forced increasingly through the dollar. And that would redirect the onus of global rebalancing away from the American consumer onto the backs of Europe, Japan, and China. Call it a “beggar-thy-neighbor” monetary policy defense -- pushing the burden of adjustment onto someone else.

It didn’t have to be this way. The big mistake, in my view, came when the Fed condoned the equity bubble in the late 1990s. It has been playing post-bubble defense ever since, fostering an unusually low real interest rate climate that has led to one bubble after another. And that has given rise to the real monster -- the asset-dependent American consumer and a co-dependent global economy that can’t live without excess US consumption. The real test was always the exit strategy.

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