... Steven Roach continues to see things from the glass is mostly empty view, J.T ... not that he has any credibility here ... <g>
Ken
_______________
November 07, 2002
Morgan Stanley's Global Economic Forum
A Dissenting View - Stephen Roach (New York)
Policy makers at the Federal Reserve did the right thing with their seemingly aggressive monetary easing on 6 November. I applaud them for that. It is impossible to fight deflation with small incremental moves. However, there’s far more to the Fed’s statement than meets the eye. It did not convey a full sense of the risks now bearing down on the US economy. Nor, contrary to widespread interpretation, did it offer any guarantees that the medicine will work.
On the surface, an aggressive 50-bp rate cut seems just what the doctor ordered. Never mind that the previous 11 moves totaling 475 bp of rate cuts haven’t worked their charm. Most believe that this one is bound to make a difference. The Fed is doing everything in its power to deepen such conviction. By stating that it has shifted to a balanced policy bias, the central bank is sending a message that this easing was the last one for this cycle. According to this logic, the only thing left now is to wait out the lags.
I beg to differ. For me, the story is all about deflation, and what the central bank must to do to prevent such an outcome. In that context, I find it hard to take confidence in a now neutral policy bias. This aspect of the Fed’s latest action was pure spin. Make no mistake, an aggressive 50-bp move is a signal of heightened alert. Yet, had the monetary authorities not qualified this action with a neutral bias, I believe there would have been full-scale panic in the financial markets. The Fed would have been portrayed as being in a state of high anxiety over mounting deflationary perils. That’s the last message it wanted to send. Instead, the central bank is attempting to convince the markets that all is under control.
The risk is the Fed is wrong. That’s because it may already be too late to arrest the gathering forces of deflation. Indeed, the latest evidence indicates no let-up whatsoever on the deflation watch. That comes through loud and clear in the just-released 3Q02 GDP report, which provides an update on the all-important GDP chain-weighted price index -- the broadest gauge of the US price level. Inflation as measured by this index slowed to just a +0.8% YoY rate in 3Q02, down more than 0.4 percentage point from the first-half average of 1.25% and equaling the inflation lows of the past 52 years. (The last time this gauge was lower came in 2Q50 with a –0.4% comparison). In the seven quarters following the last business cycle peak in 4Q00, this measure of inflation has now decelerated by 1.5 percentage points (from 2.3% in 4Q00 to 0.8% in 3Q02). That’s literally five times the 0.3 percentage point average rate of disinflation that has occurred over comparable seven-quarter intervals during the past six business cycles.
But it’s the breakdown of the aggregate price level by type of product -- goods, services, and structures -- that raises the greatest concern on the deflation watch. For goods, price change has gone from +0.7% YoY at the business cycle peak in 4Q00 to outright deflation of –0.8% in 3Q02 -- a swing of –1.5 percentage points. That is also five times the deflationary swing of –0.3 percentage point that was recorded, on average, over the comparable seven-quarter period of the past six cycles. Moreover, the cushion from non-tradable services, which has long buffered deflationary pressures in tradable goods, is getting thinner and thinner. In 3Q02, the services piece of GDP-based inflation had slowed to just 1.8% YoY; that’s down 1.2 percentage points from the 3.0% rate prevailing at the last business cycle peak in 4Q00 -- in sharp contrast with the +0.1 percentage point acceleration in services inflation that has occurred, on average, over comparable seven-quarter intervals of the past six cycles. In other words, an extraordinary deflationary shock in tradable goods has coincided with outsize disinflation in services, resulting in the most deflation-prone business cycle of the modern post-World War II era.
And yet the Fed is trying to persuade us that it has now done enough to arrest this deflationary dynamic. Of course, that is the same argument that has been made repeatedly since this monetary easing cycle began now some 525 bp ago back in early 2001. The place where I always get stuck in this argument is on the issue of traction -- which sectors of the US economy can now be expected to respond to the Fed’s monetary stimulus. There are three obvious candidates -- the interest-rate-sensitive sectors of consumer durables, homebuilding activity, and business capital spending. In my opinion, the response of each of these sectors to Fed easing is likely to prove most disappointing. Here’s why.
Normally, at this stage in a business cycle, there is a good deal of pent-up demand for items like cars and homes; as such, lower interest rates typically are quite effective in unleashing that demand and spurring vigorous recovery. That’s unlikely to be the case in the current cycle. Demand in these two sectors never fell in the recession of 2001 and they have remained resilient in the subsequent recovery. That means there is no pent-up demand that can now be unleashed by Fed easing. Just ask Detroit, where car buyers are now suffering from zero-interest-rate fatigue. The same is true of capital spending -- a sector that remains constrained by the twin pressures of the capacity overhang of the late 1990s and the ongoing imperatives of corporate cost cutting. In a deflationary climate, why would businesses compound their lack of pricing leverage by adding to aggregate supply? Fed easing is unlikely to change the capex calculus in the current climate.
Don’t get me wrong. I’m not saying that the Fed should have done it any differently on 6 November. What I am saying is that it may well be wrong to conclude that this action will be the silver bullet that sparks cyclical recovery and eliminates deflationary risk. The neutral bias announcement from the Fed is intended to persuade us that such a rosy scenario is now at hand. Once again, I suspect we’ll be disappointed in the outcome, and that the Fed will have to change its mind. The time honored anti-deflationary drill requires a central bank to be both aggressive and early in its monetary ease. The Fed is now trying its best to be aggressive, but the risk is it may be too late.
morganstanley.com |
