America's Policy Cul-De-Sac
International Perspective, by Marshall Auerback
April 29, 2003
Like any Texan worth his salt, President Bush realises that when you slam your gun on the table at the saloon, you’ve got to be prepared to use it. By the same token, now that Chairman Greenspan has unholstered his “unconventional policy gun”, it seems only a matter of time before the markets demand that he put up or shut up. Military actions in Afghanistan and Iraq respectively have clearly demonstrated the President’s willingness to pull the trigger when circumstances dictate. Can the same be said about the Fed, or has it become a prisoner of its expectations management game?
We pose these questions in light of a recent presentation to the National Association of Business Economists by Vincent Reinhart, a director of the Division of Monetary Affairs on the Board of Governors of the Federal Reserve, who (as the title of the speech implies) was given the specific task of discussing the policy tools appropriate to combat deflation (“Tools for Combating Deflation”, March 25, 2003). This is not the first instance of a member of the Federal Reserve taking on the dreaded spectre of deflation. A previous iteration was given by Governor Benjamin S. Bernanke last November.
But despite the bravado expressed by Governor Bernanke at that time, thus far there is neither a consensus on how to deal with the incipient deflationary pressures implied by a zero per cent interest rate, nor agreement on the extent to which a central bank ought to be constrained by prevailing economic orthodoxy. Federal Reserve officials are beginning to come to grips with the severe negativity of a drift into deflation, yet for all of the previous trial balloons floating resorts to unconventional measures, the Reinhart speech demonstrates a renewed hesitancy to break out of the conventional menu of policy options available to central bankers when dealing with this unique threat.
In an article in Britain’s Financial Times last week, Goldman Sachs’s Bill Dudley and PIMCO’s Paul McCulley suggested that the American economy “needs a buffer of inflation above price stability to ensure that monetary policy has room to work effectively in the event of shocks to aggregate demand” (“Greenspan must go for higher inflation” – Financial Times, April 24, 2003). By contrast, reading Mr Reinhart’s speech, one is struck by a renewed hesitancy on the part of the Fed, and distinct lack of urgency to embrace fully the policy recommendations of Dudley and McCulley.
We guess that the Fed has been somewhat spooked by the market’s reaction to Bernanke’s now notorious speech and his extolment of the “electronic printing press”. After all, as Dudley and McCulley suggest in the FT article, expectations ultimately drive markets, and here the Fed is in a sense a prisoner of its own failed expectations management game. Having dismissed the possibility of a serious deflationary threat, a sudden attack on a supposedly non-existent problem would implicitly call attention to previous policy failures, thereby undermining market confidence and detracting from the aim of promoting a greater appetite for risk amongst investors in post- bubble corporate America. This is precisely the opposite outcome that Dudley and McCulley wish to achieve through their recommendation that Greenspan go for higher inflation.
Reinhart speaks of the “considerable uncertainty [that] attends both the outlook and potential remedies” in a deflationary environment, even while acknowledging the risks of policy procrastination, as evidenced by the Japanese experience:
“The major misjudgment the Bank of Japan may have made was in the early 1990s, when policymakers showed a reluctance to respond to emerging signs of economic weakness for fear of re-inflating asset prices. However much you find the prevailing metaphor to be appropriate that rapidly rising asset prices divorced from fundamentals are a bubble, you have to admit that the comparison is apt for the aftermath: It is as difficult to blow up a balloon that has burst as to reinflate an asset price bubble once investors’ optimism is gone.”
But recognition of the risks of delay inspires nothing stronger than a Hamlet-like display of indecisiveness on the part of Reinhart: “And it is even more problematic to gauge the range of potential outcomes on the world stage, their relative probabilities, and their consequences for the economic behavior of households and firms...” (our emphasis).
In the lexicon of economics, Mr Reinhart is telling us that the Federal Reserve has no idea what happens to the money demand curve when they start promoting an explicit inflationary policy. The Fed may well hope the flow demand for dollars increases through “a quantity channel [which] may well spur spending through increases in the size of banks' balance sheets or their willingness to lend.” Alternatively, "asset prices...adjust sufficiently [to Fed liquidity creation] to stimulate spending…No doubt all of these policy mechanisms are uncertain” (our emphasis).
On the other hand, Reinhart does not explicitly disavow Bernanke in this speech. He notes that “Chairman Greenspan and Governor Bernanke have recently outlined the litany of policy responses”, and specifically cites the period preceding the Federal Reserve-Treasury Accord of 1951 in which the Fed explicitly supported 25-year bonds by fixing the price at 2.5%. Noting that the central bank can attack the term structure of interest rates directly, however, Reinhart goes out of his way to suggest that such measures are not “unusual”, “unorthodox”, or “unconventional”:
“The Federal Reserve put a ceiling on the Treasury yield curve for more than half a decade in the 1940's, used the quantity of reserves to calibrate its policy from 1979 through much of 1982, and wrote options on the federal funds rate around the century date change. What is usual, orthodox, and conventional is the Fed's willingness to adapt its policies to the circumstances.”
This speech, therefore, reflects an attempt to reconcile the differing treatments required for the equity and bond markets. Whilst painting the “unorthodox” as orthodox and conventional, the Fed has given up some of the positive surprise effect that they may have wanted to create for the equity market. On the other hand, the Fed may believe that the credit markets (and all of attendant implications that a buoyant credit market has for the crucial housing market) are a much more important determinant of keeping the great consumption boom alive and does not want that same surprise effect to impact adversely on long term interest rates.
In regard to the latter, there is some evidence to suggest that the Bernanke speech had an undesired bifurcating effect on inflation expectations, with the investor class (led by Bill Gross) assuming this meant reinflation was on the way and thus widening the spreads between TIPS and nominal bonds, i.e., building in a bigger inflation risk premium. But at the micro level, consumers have not been exhibiting any greater fear of inflation, and very few of them have ever heard of Bernanke or his printing press threat. The end result has been the same degree of actual disinflation, yet higher bond yields than would otherwise have eventuated in the absence of the speech.
There is clearly a fine line between reassuring equity investors (who generally care about more about corporate profits more than inflation) that there is a determination to avoid a Japan-type experience at all costs on the one hand whilst, on the other hand, seeking to pacify bond investors, who may legitimately fear that an enthusiastic embrace of debt-confiscating inflation may erode the value of their holdings. This is particularly the case with foreign holders of US Treasuries, who may also be worried about being paid back in substantially devalued dollars.
Reinhart does try to strike a balance in his presentation, even while expressing the prevailing Fed belief that now that the depressant of geopolitical uncertainty out of the way, the US economy will do just fine: “No doubt, there are ongoing impediments to satisfactory growth in the United States, but policymakers have reason to believe that the current stretch of sub par growth will be modest both in terms of magnitude and duration.” He therefore implies that Greenspan and Co. will wait a further period before taking additional monetary stimulus steps, in the hope that the stock market will surge and demand will follow.
But what if the Fed has miscalculated? Then, the true significance of Reinhart’s speech is revealed for all to see – namely, to provide the template as to how the Fed will try to paint its first foray into unconventional territory without making these measures appear as panicky responses to an already dire situation. In essence, the presentation is an attempt to paint the opening moves of unconventional policy as conventional - in order to avoid having to admit that conventional policy measures had failed, and that deflation is already playing havoc on corporate profitability. Hence the real reason for the change orientation from Bernanke's speech to the current rendition: it may be the means by which the Fed has reconciled its organisational imperative to act incrementally with its need to go unconventional.
Is this reconciliation credible? Whatever the Fed might say about pegging long-term rates not being "unconventional" because of the precedent established from the 1940s, the simple fact is that we inhabit a very different monetary universe today. The historic analogy does not in reality provide any kind of clarity in terms of future policy outcome. What would this pegging of long term rates do to the GSEs? To foreign demand for dollar bonds? To the derivatives market? The Fed really has no idea. Reinhart can celebrate the Fed’s apparent willingness to “adapt its policies to the circumstances”, but at some stage, this “adaptation” will invariably metamorphose into something strikingly unorthodox and unconventional, however the Fed chooses to describe it.
In fact, Reinhart implicitly recognises the implications of being too conventional, acknowledging that “some shocks may be too large and too persistent for monetary policy to offset completely.” Is the US economy in this position today?
His presentation does dwell on the limitations of monetary policy in the event of a fully fledged deflation: “[I]t is possible that the requisite real interest rate required to pull up aggregate demand to potential output may be too deeply negative to achieve immediately, as it may be difficult to engender sufficient inflation expectations.” In the US this problem is further complicated by the fact that the private sector has as yet undergone little in the way of balance sheet repair. It appears inconceivable therefore that the private sector will provide the motor for expansion by plunging deeply once again into deficit, if only because of the unusually high level of debt which has already been incurred both by corporations and by the personal sector.
There is always recourse to fiscal policy, but as we noted last week, the requisite public sector dis- saving is of such a scale that it would be impossible to envisage a political context in which Congress and the President (and, indeed, the credit markets) would tolerate a general government deficit sufficient to cover the current deficit of the private sector (now over 6 per cent and rising). The building opposition to President Bush’s tax plan, particularly on the part of deficit hawks in his own party, is symptomatic of the inability of Congress to recognise the full scale of the problems now facing the economy. Fiscal policy is handcuffed by the fear of a return to the twin deficits, with all the adverse consequences this might portend for the bond market, yet financial balances theory suggest that some other sector has to take up the slack if the private sector goes on a savings binge.
There would appear to be only one other antidote to this predicament – namely, that net export demand provides the motor for sustained growth in the future. U.S exports must rise faster than imports by very large amounts and for a long period of time, which implies a weaker dollar.
There is no question that dollar weakness has broadened recently, now extending well beyond the euro. According to Germany’s Der Spiegel magazine, “The U.S. is trying to push the dollar lower against the euro to narrow its trade deficit and retaliate against Germany and France for their opposition to the Iraq war.” ‘This will be Europe's invisible contribution to our Iraq costs,’ an unidentified U.S. official told European policy makers in Brussels, according to the magazine. The U.S. has given up its strong dollar policy, the official said.”
To the extent that the foregoing statement implies full American control of its own economic destiny, we think the unnamed American official quoted in Der Spiegel misspeaks. To suggest that the US “has given up” its strong dollar policy implies that the US in some way still possesses the independent means to control external value of its currency. We are beginning to doubt this assessment.
For all the recent discussion of dollar weakness, there has been little noticeable improvement in the US external account. In part this is a lagged effect of the continued strong dollar throughout the 1990s against its main trading partners, despite mounting external imbalances. The lags in trade are considerable; arguably it is only now that all of the volume effects subsequent to the dollar rise of the late 1990s are being manifested in the trade figures. These lags have tended to widen the current account deficit, notwithstanding the improvement in emerging Asia's overall domestic demand since the 1997/98 fall-out.
It is also becoming increasingly apparent that surplus countries (e.g. Japan, emerging Asia and China) are accumulating mountainous reserves which they have been using to prevent any natural rebalancing process from taking place. How can this be? For one thing, most of these countries, notably China, still manage their currencies closely against the greenback. That means that mounting pressures toward further dollar weakness have simply had the effect of driving the Yuan lower as well, and since China is the marginal price setter in so many areas (and these are increasing in number constantly), this tends to exacerbate global deflation, keeping US equities under downward pressure because (a) US corporate earnings and employment get worse, and (b) lower ex ante stock prices are needed to lure the volume of external investment required to prop the dollar. It also means very little improvement in the external account for the US. Under such circumstances, it is possible to imagine circumstances under which recourse to protective tariffs might be the only way in which America’s strategic problem can be solved. Needless to say, this is hardly a benign environment for global equity markets and serves to reinforce the limited conventional options available to the Fed going forward.
Consequently, it is inevitable that the Fed will at some stage head down the end route of unorthodox monetary policy if there is no clear pickup in the investment-spending cycle or consumption soon. In this respect, news of Greenspan’s probable reappointment as Chairman announced last week may have made the Fed’s job that much more difficult. As Goldman Sachs economist John Youngdahl notes, “A Greenspan-led Fed that attempts to frighten consumers and businesses into spending more on the threat of monetization is apt to be less successful than a Fed led by someone else without Greenspan's history.” This was presumably part of the thinking that underlined the President’s wholesale changes in his economics team last year, although notwithstanding these changes, it is clear that tax policy remains similarly hamstrung by undue attachment to prevailing fiscal orthodoxy. The level of stimulus mooted thus far comes nowhere near what will be required to alleviate the inevitable adjustment that will arise as the private sector moves to pay down debt and increase savings. A “controlled” dollar devaluation is no longer something that can be unilaterally determined by US monetary and financial officials alone; the Chinese now have a profound say in this matter.
Having let the markets know that “unconventional policies” are on the table, we have no doubt that the Fed will eventually be forced to use them, even as its natural bureaucratic instincts will delay this outcome for as long as possible. The Federal Reserve is full of conservative bureaucrats, not Texas gunslingers. Whether the resort to unorthodox measures will do any good is another matter. For all the talk about the parallels to Japan, its lack of good policy options makes America’s predicament looks increasingly like that of Argentina circa 2001. And we know that particular saga did not end with anything particularly unconventional or unorthodox, but simply a wrenching and painful economic adjustment, whose impact is still being felt in that country today.
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