Don't fight the Fed:
From Morgan Stanley
Global: On Fighting Central Banks
Stephen Roach (New York)
Even in the New Economy, it may still pay to heed old rules. For investors, one of the oldest is,
"Don?t fight the Fed." Whether or not that adage can be amended to include the ECB is an open
question. But it?s increasingly clear to me that two of the world?s major central banks are on a
tightening path that poses considerable risks to ever-complacent investors.
There are five key dimensions of central bank risk that I believe will bear most critically on world
financial markets in 2000. The first is an important tactical shift in the approach to monetary policy.
The central bank tightening of 1999 was all about "normalization" -- returning policy settings to the
pre-crisis norms that prevailed in early 1997. While the Fed and the ECB have succeeded in
normalizing nominal short-term rates, they have not accomplished this objective from the standpoint
of real interest rates. That?s because there has been an oil shock that has boosted headline inflation
about 0.5 percentage point above pre-crisis norms. In other words, real interest rate normalization
requires more tightening than nominal interest rate normalization; while G-2 central banks have
accomplished the latter, they have not achieved the former.
But there?s more driving central banks in 2000 than policy normalization. A second dimension of
policy risk is the coming transition to a more classic counter-cyclical monetary tightening. That?s
especially the case in a fully-employed US economy, where the Fed is now going out of its way to
state quite explicitly that GDP growth is far too fast. The US central bank has made this statement in
the context of a significant upward revision to traditional macro speed limits; old economy speed
limits were thought to be around 2.25%, whereas new economy limits are believed to be in the 3%
zone. For a US economy that has been on a 4.2% growth path for nearly five years, and 6% over the
past two quarters, enough is enough. The Fed wants a slowdown. And, by the way, to the extent that
America?s growth dynamic has been increasingly tech-led, it seems reasonable to believe that this
sector will bear the brunt of the ensuing downshift.
A third element of central bank risk is the time-honored credibility issue. As Ottmar Issing of the
ECB once said to me, "...all we central banks have is our credibility." That credibility is now under
attack. There?s the "moral hazard play" in the United States, where many believe that the Fed is
trapped in the context of an equity market that has become too big too fail. And there?s the ECB?s
own dilemma, with a sagging currency symbolic of a new wave of politically induced
euro-skepticism; in that same vein, Joachim Fels has also made the point that the ECB may simply
believe that its policy rates are too low to effectively manage the Euroland economy. There?s only one
way to regain the upper hand on the credibility front -- more aggressive tightening than financial
markets are expecting.
A fourth consideration is the ever-present 500 pound gorilla -- over-valued equity markets. This is
obviously a very big issue for the Fed and a lesser one (but growing) for the ECB. Alan Greenspan
has recast this issue completely since he first opined over "irrational exuberance" in December 1996
(at Dow 6437). In last week?s Humphrey Hawkins testimony to the Congress, he was quite explicit
in equating the US economy?s growth excess to the wealth effect: By his reckoning, it was roughly
equivalent to one percentage point of extra GDP growth. The fact that this excess is thought to be
largely stock-market-induced is hardly idle conjecture. Nor does it matter that stock market strength
is narrow or broad. The US central bank has been very deliberate in expanding its explanation of
what drives the real economy -- adding an increasingly powerful wealth effect to traditional income
effects. The Fed, in my view, is sending an increasingly clear signal that a macro growth excess --
irrespective of its source -- must now be eliminated. While this need not be interpreted as a strategy
of explicit equity-market targeting, it could well be tantamount to a strategy of implicit equity market
targeting.
Fifth, is incrementalism. Neither the Fed nor the ECB seem likely to make large interest-rate
adjustments at upcoming policy meetings. With core inflation still low, they have the luxury of
sticking to 25 bp tightening dosages. Moreover, with real economies more and more dependent on
financial markets, the possibility of destabilizing, asymmetrical wealth effects cannot be ruled out if
equity markets finally correct. Incrementalism allows central banks the luxury of backtracking should
their policy actions prove too disruptive. That, of course, would underscore the ultimate moral hazard
dilemma all the more. My own guess is that G-2 central banks would welcome an "orderly"
correction in over-valued equity markets. Maintaining an incremental approach to tightening would
enable the authorities to tough out the inevitable aftershocks.
There is an over-arching theme to all of the above. In the depths of the financial crisis (late 1998),
central banks eased aggressively in order to save the world. In doing so, they essentially abdicated
control over their real economies and financial markets. Global healing was a signal that policy
normalization was in order. But now as the world moves beyond healing, it is imperative for central
banks to act in order to regain control. The longer they wait, the tougher that task will be. The risk is
that short-term interest rates in both the United States and Europe may have to rise a good deal more
than the 50 to 75 bps that financial markets (and our US and Euroland economists) expect. New
Economy or not, some things never change. Don?t fight central banks. |
