Global: Fed Landing Tactics
Stephen Roach (New York)
As the US economy comes in for a landing, the role of the Federal Reserve takes on enormous importance. The financial-market response to Fed chairman Alan Greenspan’s latest utterances certainly drives this point home (see David Greenlaw’s dispatch in today’s Forum for a dissection of the chairman’s speech). The Fed chairman offered an important reminder that the character of the coming landing will be decisive in shaping monetary policy. In a soft landing, the central bank’s priorities are likely to be influenced by a residue of inflation risks. But if a hard landing comes to pass, the downside of the wealth effect could quickly emerge as the biggest concern. There are striking differences in the policy ramifications of these two scenarios.
I agree with Dick Berner that the Federal Reserve is likely to be "reactive" in a soft landing. And why shouldn’t it be? A soft landing is designed to alleviate cyclical pressures and prolong an economic expansion. It tolerates an interlude of subpar growth as the means toward a greater end -- creating enough slack in labor and product markets to keep wage and price pressures at bay. However, unless the US unemployment rate rises toward 5%, there’s probably little reason to look for a dramatic reduction in unit labor cost pressures, especially if the cyclical productivity windfall starts to wane in a climate of slower GDP growth. In fact, over the next year, our forecast suggests that the risks remain tilted in favor of a likely rise in long-dormant unit labor costs, hardly a comforting development for an inflation-focused central bank. Add in the pressures of higher energy prices, and it is easy to understand why the Fed would drag its feet. In a soft landing, the macro outcome could well border on stagflation -- slower growth but persistent, and possibly rising, inflation. Under such a scenario, any Fed easing would occur only grudgingly.
In a hard landing, it could be a different matter altogether. Here’s where Greenspan’s latest remarks are so revealing. Perhaps it was a sheer coincidence, but he used the occasion of the fourth anniversary of his now infamous "irrational exuberance" speech to underscore the perils of the wealth effect. I don’t think it was an accident, and I couldn’t agree more. A negative wealth effect is the biggest risk of all in a hard landing. That’s because the stock market is still vulnerable to the extreme disappointments in corporate earnings that would occur in an outright recession. Dick Berner has stressed that a soft landing in the US economy could well be accompanied by a hard landing on the earnings front; his current baseline forecast underscores that possibility -- a 3% (y-o-y) rise in real GDP in 2001, accompanied by just a 0.9% increase in after-tax profits. But if a soft landing produces virtually no change in corporate profits in 2001, I could easily conceive of a 15-20% decline in a hard landing, close to the norm of past earnings contractions. Under such circumstances, the risk of another sharp downleg to the US stock market would become a very real possibility.
Another big hit to the stock market would underscore the perils of the dreaded "asymmetrical wealth effect" -- whereby a down market hurts the economy more than an up market helped it. Three key characteristics of US wealth dependency could set the stage for such a response: a record incidence of ownership and exposure to equities as an asset class; an aging US population that is closer to retirement than ever before; and pension regimes that have shifted increasingly from defined benefits to defined contributions. Against, that backdrop, another downleg in the stock market could evoke a powerful wealth preservation response that would put pressure on wealth-dependent American consumers to revamp depleted income-based saving rates. And that would pose a set of risks that could prove most problematic for the Fed.
That’s not to say that the wealth effect of a soft landing isn’t already kicking in. According to David Greenlaw, it is now adding only about +0.8 percentage point to real consumption growth, down from the +1.2 percentage point boost that occurred during 1997-99. But there’s plenty more to come in the pipeline. Under the assumption that the Wilshire 5000 simply holds at the level prevailing on November 30 -- down 16% from its peak -- Greenlaw calculates that the wealth effect would be subtracting -0.8 percentage point from growth in consumer demand by the end of 2001. That would represent a swing of fully two percentage points from the boost of the past several years. That’s a powerful headwind by any standards and quite consistent with what Greenspan has just conceded is a "significantly attenuated" wealth effect.
Yet in the overall scheme of things, the negative wealth effect that is now emerging is coming from the gentlest of all possible stock market corrections -- a 16% dip in the broad market following five years of 25% gains. Under a hard landing scenario, I wouldn’t be surprised if the stock market fell another 15% from present levels and stayed there for at least six months. That’s the alternative I believe would trigger the asymmetrical wealth effect and an attendant rise in personal saving. In a previous dispatch, I attempted to scale the magnitude of such a response (see my November 8, 2000, note, "Ill Winds"). I pointed out that if the personal saving rate were merely to recoup half the precipitous decline that has occurred over the past six years -- and return to a still subpar 3.3% reading -- personal consumption growth would have to slow to about 1% for three years. When compared with 4.5% average growth in real consumption since 1995, such a scenario would represent a devastating turn of events -- a three-year shortfall of more than three percentage points annually from the recent trend.
The Federal Reserve can ill afford such an outcome. It has the aftershocks of a post-bubble US economy written all over it. Those are the same Japanese-style perils that Greenspan first warned of on December 5, 1996. While he stressed at the time that that the Fed "need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy," he conceded that the central bank can hardly afford to "become complacent about the complexity of the interactions of asset markets and the economy." Precisely four years later, Greenspan drove the same point home again, stressing his concerns over the possibility that "weakening asset values in financial markets could signal or precipitate an excessive softening in household and business spending." In a hard-landing-driven shortfall of consumer demand, the Fed’s worst nightmares would come true. The central bank, under those circumstances, could be expected to ease very aggressively in an effort to stave off the earnings collapse that would produce such an outcome. A wealth-induced hard landing is the very last thing it wants.
In the end, it boils down to a tale of two landings. In a soft landing -- everyone’s favorite and most likely scenario -- Fed tactics would still be shaped by a residue of inflation targeting. Conversely, in a hard landing, policy tactics would be focused more on asset-market targeting. Since a soft landing gives the central bank largely what it wants -- a manageable slowdown -- any easing should be limited. Conversely, in a wealth-induced hard landing, precisely the opposite would occur -- the Fed would be getting exactly what it doesn’t want. If, in fact, that’s where the US economy is headed, I wouldn’t be surprised to see the federal funds rate go well below 5% during 2001. |
