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> Subject: ROACH - A Time for Courage...........
> Date: Fri, 05 Mar 2004 07:30:38 +0000
>
> A Time for Courage
>
> In its most practical sense, macro is best at identifying risks. And in
> my view, the balance of risks in the US economy has shifted. It was
> just about a year and a half ago when I first sounded the alarm on
> deflation (see my 14 August 2002 dispatch, "A Deflationary Mosaic").
> Today, I am more worried about inflation. But it's inflation with an
> important twist -- not the CPI-based inflation of product markets but
> the asset inflation of financial markets. I fear that America's
> post-bubble recovery is in serious danger of spawning a new round of
> asset bubbles that could well pose the most deflationary risks of all.
>
> The Federal Reserve's post-bubble policy gambit is at the heart of my
> concerns. By holding the nominal federal funds rate at just 1% in the
> context of a 1% core inflation rate, a "zero" real federal funds rate
> sticks out like a sore thumb in the aftermath of 6% real GDP growth in
> the second half of 2003. That's even more apparent when judged against
> the Fed's own forecast of 4.5% to 5.0% real GDP growth over the four
> quarters of 2004. No one doubts that America's central bank is
> injecting extraordinary stimulus into the financial system. The debate
> is over the impacts of these efforts. That's where it gets tricky.
> Monetary policy is a very blunt instrument. The authorities can set the
> overnight bank lending rate but they have little say on the channels of
> the policy transmission mechanism. In particular, there are no
> guarantees that policy stimulus goes directly into the real economy or
> into the financial markets.
>
> This ambiguity is especially worrisome in the current climate.
> Inflation in the traditional sense is not a problem. Sure, commodity
> prices are now surging, but unit labor cost pressures are going the
> other way -- down 1.7% on a year-over-year basis through 4Q03. With
> labor accounting for five to six times the share of commodities in the
> overall business cost structure, the forces of disinflation continue to
> have the upper hand. That shows up loud and clear in the ongoing
> deceleration of underlying inflation -- a core CPI inflation rate that
> has slowed from 1.9% y-o-y in January 2003 to 1.1% in January 2004. But
> with the US economy having rebounded sharply in the second half of last
> year and expected to record a solid increase in 2004, the gap between
> aggregate supply and demand is finally beginning to close. For that
> reason, alone, it is now safe to conclude that the risks of an immediate
> deflation are receding -- at least for the time being. At the same
> time, with most businesses lacking in pricing leverage and labor costs
> still contracting, the odds of a spontaneous acceleration in inflation
> are exceedingly low, in my view.
>
> Alas, that doesn't mean the Fed's aggressive reflationary efforts have
> disappeared into thin air. With inflation in goods and services low and
> still falling, the impacts of monetary stimulus appear to have spilled
> over into financial assets. The property market is a case in point.
> Nationwide home prices surged at a 14.7% annual rate in 4Q03, according
> to figures recently released by the Office of Federal Housing Enterprise
> Oversight (OFHEO). That brought the year-over-year appreciation in
> housing prices to 8.0% in yearend 2003; that nearly matches the 8.2%
> peak rate of nationwide housing inflation hit in mid-2001 -- the
> strongest gain since the inception of this series in 1990. Housing
> experts and central bankers are always quick to stress the regional
> cross-currents in US property markets -- all but denying the possibility
> of extremes in nationwide property appreciation. Let the record show
> that all but two states experienced house price appreciation in the
> final period of 2003, according to detailed OFHEO statistics.
>
> Nor is property the only asset class displaying bubblelike tendencies.
> The same can be said for most fixed income instruments, starting with
> long-dated Treasuries. That shows up most clearly in the real interest
> rate component of nominal Treasury yields, which currently stands at a
> near record low of 1.6% for a 10-year maturity as measured in the
> so-called TIPS market. For rapidly growing US economy plagued with the
> twin deficits of outsize fiscal imbalances and a massive current account
> deficit, there is a compelling case for considerably higher real
> interest rates. The same can be said for most "spread products" --
> especially corporates, high-yield debt, and emerging market securities
> -- where yield gaps relative to Treasuries remain at cycle lows. Our
> credit strategist, Greg Peters, argues that the problem may lie less in
> the spread and more in the absolute level of yields on these riskier
> assets. Inasmuch as I believe that the Treasury benchmark, itself, is
> sharply overvalued, I don't draw much comfort from that observation.
>
> I continue to believe that the mounting froth in both property and fixed
> income markets is largely traceable to the Fed's extraordinary policy
> stimulus. Low interest rates continue to fuel the excess demand and
> price behavior in the housing sector. Moreover, with the US central
> bank anchoring the short end of the yield curve at 1%, commercial banks,
> institutional investors, and speculators are all rushing to take
> advantage of what could well be the "mother of all carry trades."
> There's no secret that this is the biggest and probably the most levered
> bet in financial markets today. The risk of multiple asset bubbles can
> only intensify as the Fed clings to its stance of extraordinary
> accommodation in the face of a rapidly growing and still inflationless
> US economy. With excess liquidity creation not being absorbed by the
> real economy, it is now slopping over into an increasingly broad array
> of asset markets. That's what bubbles are all about.
>
> These are the concerns that prompted me to make the seemingly outrageous
> suggestion that the Fed normalize its policy stance by immediately
> hiking the federal funds rate to 3% (see my 27 February dispatch, "Open
> Letter to Alan Greenspan" also published in the 1 March edition of
> Newsweek International). I have taken a lot of flak for making this
> suggestion. The main objections are that such a policy shock could
> quickly unwind the carry trades and do great damage to an
> overly-indebted US economy -- especially the ever-oblivious American
> consumer. It's hard to argue with those concerns. But that's not a
> good reason, in my view, for holding interest rates artificially low and
> creating the even greater danger of multiple asset bubbles. There are
> those, of course, that insist central banks have no right to overrule
> the verdict of the millions who freely vote in financial markets every
> day. But then there are others -- most recently the ECB's Otmar Issing
> -- who argue that central banks must now take heed of "the risks
> associated with asset-price inflation and subsequent deflation" (see
> "Money and Credit" in the 18 February edition of The Wall Street
> Journal). I suspect that history will long take note of the outcome of
> this debate.
>
> As we all should have learned four years ago, the asset bubble is the
> gravest risk of all. And that could well be the ultimate irony of the
> great inflation-deflation debate. From the start, my case for US
> deflation was critically dependent on the perils of a post-bubble
> shakeout. History tells us that most serious deflations arise from just
> such circumstances. Just ask Japan, or take a look at America in the
> 1930s. For the time being, a rapidly growing US economy may well have
> sidestepped the immediate perils of a CPI-based deflation. But it may
> not be so lucky in the aftermath of the bursting of another asset
> bubble. Unlike the situation four years ago, when the Fed had 600 basis
> points of ammunition to fight the post-bubble damage-containment battle,
> the central bank only has 100 bp left in its arsenal today.
>
> With risks of new asset bubbles rising, there is a growing urgency for a
> normalization of US interest rates. Unwinding an ever-dangerous carry
> trade is a small price to pay to avoid the most treacherous endgame of
> all. America, in my view, is probably only one bubble away from
> outright deflation. Paul Volcker had the courage to stand up to
> inflation in 1979. Now it's up to Alan Greenspan to wage an equally
> heroic battle.
>
> Stephen Roach (from London)
>
>
> --
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