Global: Aftermath
Stephen Roach (from Morgan Stanley)
In the end, it was expected. Financial markets were hardly shocked by the Federal Reserve?s 50 bp rate hike of May 16.
Yet investors remain unfazed over what comes next. Fixed income markets seem to be discounting only another 50 bp of
tightening over the next few months. And equity markets continue to be priced for a Fed that remains very much in control
of the upside of the inflation cycle and the downside of the growth cycle. The key issue for financial markets, in my view,
is whether these assumptions will be challenged in the months ahead.
The importance of the May 16 policy action was twofold: The Fed has abandoned incrementalism, and it has left the door
wide open for subsequent policy actions. To me, this speaks of a central bank that has finally recognized the gravity of the
cyclical risks that are now unfolding. The good news is that the potential acceleration of inflation is beginning from a very
low level. The bad news is that it is occurring in the context of the tightest domestic labor market in 30 years and the most
vigorous global economy in 13 years. In such a cyclical context, the Fed can no longer afford to err on the side of
accommodation, as it has repeatedly in recent years. This is a climate that demands a much tougher policy stance.
Unfortunately, the Federal Reserve does not enter the cyclical stage in a position of strength. With inflation now having
risen to 3% -- and expected to remain there through 2001, according to Dick Berner -- a nominal federal funds rate of
6.5% translates into a real funds rate of just 3.5%. This is only slightly above the longer-term average of 3% that is widely
characterized as "neutral" -- a real short-term interest rate that imparts neither restraint nor accommodation to the real
economy. For a fully employed US economy that has been on a 4.5% average growth track over the past four years, such a
modest degree of policy restraint is not sufficient, in my view, to contain the cyclical risks that are now just beginning to
emerge. Indeed, according to Dick Berner?s baseline scenario, if future Fed actions simply match the 50-65 bp of
tightening currently being discounted by fixed income markets, the US economy would still grow by 3.7% in 2001. Such
a growth outcome would do little, or nothing, to relieve the build-up of cyclical pressures now under way. In my view, it
will take far more monetary tightening to give the Fed the traction it needs to contain cyclical risks.
What about the lags? That?s a question that investors ask me quite frequently these days. After all, the Fed has now raised
official rates by 175 bp in six installments over the past 10 months. The lags of monetary policy adjustments have long
been thought to be long and variable -- taking as much as 12-18 months to take effect. Shouldn?t the Fed simply sit back
and await the fruits of its labor? This would be a tactical blunder, in my view. As I have argued above, the authorities have
only just taken real short-term rates into the restrictive zone -- and just barely, at that. The impacts of this move won?t
begin to show up until mid-2001, at the soonest. Until that occurs, there?s little to stop the economy from ripping ahead at
the 4.5% growth pace its been on for four years -- an outcome that would only intensify emerging cyclical pressures all the
more. In short, the Fed can ill afford the luxury of waiting for the lags to play out.
Yet financial markets sense no urgency to the tale that is about to unfold. It is out of such complacency, of course, that
significant and sustained corrections ultimately arise. In my view, the biggest risk in this regard is that the Fed has now
made up its mind that it needs to engineer a soft landing for the US economy. And given the cyclically advanced state of a
fully employed labor market, an even bigger surprise would be if the Fed defines a soft landing as a 2% to 2.5% growth
outcome. Such a pace is not only significantly below the economy?s longer-term potential but one that falls far short of
that driving the still optimistic earnings expectations embedded in equity prices. The logic of such a strategy continues to
escape most investors. But it rests on the simple premise that it would take a sluggish -- i.e., below-potential growth
outcome -- to open the slack that would be required to dampen cyclical pressures.
World financial markets are not priced for such a soft landing in the United States. Nor are they priced for the full extent
of the Fed tightening that would be required to produce such an outcome. Investors are convinced that the secular forces of
disinflation are more than sufficient to outweigh any cyclical pressures. Key in this regard is that US and global GDP
growth will remain vigorous. That could well be the weak link in the financial market daisy chain. Vigorous growth is at
the core of still elevated world equity markets. Any threat to this key underpinning must, therefore, be taken seriously.
Meanwhile, the balance of risks has shifted. Cyclical forces now loom more important than the secular ones in shaping the
macro climate. That now puts growth at risk, in my view. In the aftermath of May 16, the utopia bet is living on borrowed
time. |
