Stephen Roach (from Hollywood)
Global: 550 Basis Points and Counting
It was a very different era. In June 1958, the number one song in America was “Who’s Sorry Now” by Connie Francis. That same month the federal funds rate averaged 93 basis points. Fast forward 45 years and the Federal Reserve has taken its policy rate to a new post-Connie Francis low. By pushing the federal funds rate down to the long-forgotten 1% threshold, the Fed has rewritten the script of modern-day monetary policy. The fight against inflation is over. The battle against deflation has been joined.
The macro framework to assess the outcome of this battle is relatively straight-forward. Since the equity bubble popped in early 2000, the US economy has been on an anemic 1.7% annualized growth path. That includes a mild recession in the first three quarters of 2001 and an unusually subpar recovery in the subsequent seven quarters. Significantly, the post-bubble growth pace has been well below America’s productivity-driven potential growth rate that most put in the 3.25% to 3.75% zone. The result is the emergence of a wide margin of slack between aggregate supply and demand. For a US economy that entered this post-bubble business cycle at a 2.25% inflation rate, this slack has been sufficient to push the US dangerously close to the deflation threshold; in the first five months of 2003, annualized core CPI inflation has averaged just 1.2%. Little wonder the most common complaint heard from US businesses pertains to the lack of pricing leverage. In this context, the Fed’s goal is simple -- to get the economic growth rate back above its long term potential and hold it there for a sustained period of time. Only then will the gap between aggregate supply and demand start to narrow and deflationary pressures be arrested. At the liberty of being overly precise, I would translate the Fed’s anti-deflation objective as pushing the economy from a 1.7% growth path to a 4% trajectory -- and keeping it there for at least a couple of years.
The Fed has been unusually aggressive in attempting to achieve that objective. Thirteen easings over the past 30 months and 550 basis points later, however, the central bank has little to show for its noble efforts. It’s not the lags, in my view. By now, all conventional macro models would have expected the “policy multipliers” to have delivered -- not just on the basis of monetary stimulus but also in response to the Bush Administration’s first round of fiscal stimulus implemented in early 2001. Sure, there were several special circumstances that temporarily got in the way -- namely, the terrorist attacks of September 11, 2001 and the more recent war in Iraq. But in the aftermath of each of those disruptions, the US economy has failed to spring back. If policy stimulus was achieving the traction that traditional macro called for, there should have been a powerful post-shock snapback in each instance. But there wasn’t.
The reason, in my view, is that the current macro climate is anything but traditional. I continue to believe that America remains in a post-bubble business cycle, where most of the macro rules we have come to trust have been turned inside out. In business cycles of the past, policy traction has followed a very predictable pattern -- it initially unleashed pent-up demand in consumer durables and homebuilding activity, which created multiplier effects that boosted overall personal consumption that then sparked a lagged upturn in capital spending. In today’s post-bubble climate, America is lacking in pent-up demand. Consumer durables and homebuilding never went down in the recession of 2001 and then rose to record highs in the anemic recovery that has since followed. As a consequence, the ability of policy stimulus to trigger a classic cyclical snapback in these sectors is limited.
Similarly, the US and the world are still awash in the excess supply that was put in place in the late 1990s. That’s why businesses continue to complain about the lack of pricing leverage. In that context, it’s hardly surprising that the capital spending response has been muted and can be expected to remain so for some time to come. Business capital spending has fallen in real terms in nine of the past ten quarters (ending in 1Q03) -- an unprecedented downturn both in terms of duration and depth. The disappointing fallback in capital goods orders just reported for May hardly suggests that a reversal is now at hand -- despite the favorable recent improvement in cost-of-capital conditions that is likely to get further assistance by recently enacted investment tax incentives. In my view, the capex outlook is more about quantity than price -- far less dependent on cost of capital issues than it is on the sheer overhang of global capacity relative to expected demand growth. For an economy on the brink of deflation, the case for a spontaneous revival in fixed investment continues to seem like a real stretch to me. I am the first to concede that the capex outlook is absolutely central to the policy and financial market debate. Most believe that this is the sector that will spark the long awaited economic revival. I don’t. In my view, traditional policy traction always disappoints in post-bubble economies that have gone to excess. As Keynes said of the 1930s, the authorities end up “pushing on a string.” That’s been America for the past three and a half years.
That’s not to say that the massive policy stimulus of the past two and a half years hasn’t worked at all. It may well have been decisive in containing the damage that may have otherwise been done during the recession of 2001. But the task at hand is very different than recession containment -- it involves providing enough impetus to the real economy to push growth back up from the 1.7% pace of the past three and a half years to a 4% trajectory. Given the lack of pent-up demand and the lingering excesses of aggregate supply, that may be exceedingly difficult to achieve. Sure there may be quarters when the economy temporarily pops above the post-bubble norm of 2%. Such an outcome may well be in the cards at some point in the second half of this year. But there will also be quarters when the economy experiences yet another in a long string of relapses and sags below its post-bubble norm. That, in fact, was precisely the case over the past three quarters, when real GDP growth averaged slightly less than 1.5%. But, as noted above, the key objective for the authorities is to get the US economy back to a sustainable 4% growth pace -- and hold it there for several years. That’s the only way the deflationary gap between aggregate supply and demand can be closed once and for all. A temporary growth spurt won’t do the trick, and yet that’s a classic symptom of a post-bubble economy. I continue to fear that a post-bubble US economy plagued by a lack of policy traction will be unable to complete the critical transition from subpar to rapid growth. And that underscores the ultimate risk: A persistence of subpar growth in the current climate could take the US economy further down the slippery slope toward outright deflation.
Once again, financial markets are telling me that I’m dead wrong. The sharp run up in equities speaks of expectations of a sustained upturn in earnings that only a vigorous economy could deliver. The recent sharp sell-off in Treasuries speaks of a bond market that now believes that the Fed has done enough to fight deflation and spark a snapback in the real economy. Interestingly enough, the optimists on the economy, including those at the Federal Reserve, cite improved financial conditions -- not just rebounding equities but also reduced credit spreads -- as a key driver of the coming revival in the US economy. Yet, if I’m even close to being right on the economy, the markets could well be blindsided by the next in a long string of relapses. To me this is a painful replay of one of the great sins of the late 1990s. Framing a macro view of the real economy on the basis of an overly optimistic prognosis by financial markets could end up being the ultimate in circular thinking.
In its inflation fighting days, financial markets learned never to doubt the Fed. In its deflation-fighting role, markets are giving the Fed the same benefit of the doubt. My biggest fear is that the Fed’s skill-set is asymmetrical -- that the central bank is much better in fighting inflation than deflation. If I’m right, that could spell a tough reality check for the US economy and for ever-optimistic financial markets. By the way, Connie Francis also recorded another song in 1958 that didn’t quite make it to the top of the charts. The title: “I’m Beginning to See the Light.” And I am told by one of the hippest members of our team that next week’s number one album on the Billboard charts is likely to be “After the Storm” by Monica -- whoever she is. What a world! |
