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To: Cynic 2005 who wrote (81119)	12/25/1999 7:28:00 PM
From: Crimson Ghost	Respond to of 86076

Morgan Stanley chief economist Steve Roach talking about another 75 bp of Fed tightening next year and a big correction in the equity markets. Steve's record has been very good of late. From Healing to Fire? Stephen Roach (New York) As the millennium draws to a close, there can be no mistaking the extraordinary recovery in the world economy in the aftermath of the crisis-induced recession of 1998. With the notable exception of Japan, Asia has bounced back with a vengeance. Europe is ending the year on an increasingly solid note, with a long lagging German economy finally kicking in. Nor are there signs of any let-up in the great American growth saga, as yet another slowdown bet is getting blown away by a powerful upsurge that seems destined to spill over into 2000. US vigor is also driving the remainder of the NAFTA bloc to the upside, with Canada and Mexico experiencing significant upturns that should have beneficial impacts throughout Latin America. Even Eastern and Central Europe seem largely on the mend, supported by improved conditions in Russia, Poland, and the Czech Republic. Up until now, financial markets have basked in the warm glow of global healing. While interest rates have bounced back from the crisis-depressed lows of late 1998, equity markets have enjoyed unfailing support from the surprising vigor of output and earnings growth. To be sure, this has led to extraordinary valuation strains on European and US equity markets, where our models suggest that broad averages in both regions are at least 40% above "fair value." But perceptions of a new era abound. That has not only challenged the macro rules that have long governed once sacred economic relationships -- such as the timeworn linkage between growth and inflation -- but it has also questioned the relevance of the connection between bond and equity markets. New paradigm or not, wealth creation in financial markets has played an exceedingly powerful role in supporting the newfound vigor in the global economy. A key challenge for 2000 is whether this relationship will endure. The major risk, in my view, is that the relationship between financial markets and their economic underpinnings could be turned inside out. That could occur if the excesses of wealth-driven economies were to sow the seeds of a sharp correction in financial markets. How could this possibly happen? The answer, in my view, lies in the timeworn tradeoff between the structural and cyclical forces that shape economic and financial market out-comes. In our version of the new macro, the laws of sup-ply and demand have not been repealed. To the contrary, I would stress that under our baseline scenario of at least 4% world GDP growth over the next couple of years, the gap between aggregate supply and demand that was opened up in the crisis-induced global recession of 1998 should be virtually eliminated by the end of 2001. This drives our prognosis of a modest upturn in global inflation from its cyclical low of 2.4% in 1999 to 3.2% in 2001, sufficient to outweigh the ongoing structural forces of a technology-led disinflation. In the increasingly vigorous global growth outcome we envision, the balance of risks will shift from the structural to the cyclical. For financial markets, that changes everything. Most importantly, it puts the onus back on central banks as the ultimate arbiters of the macro climate. Here?s where the extremes of the new paradigm bet ask for trouble. Investors are convinced that inflation and economic growth have become permanently de-linked. We haven?t bought that view -- nor have central banks. While the authorities may have raised their tolerance of an economic speed limit, they still believe that such a threshold exists. Under that key presumption, there can be no mistaking the excesses of America?s ongoing growth vigor -- four years of 4%-plus growth violates even the most optimistic estimates of the US economy?s inflation-stable growth rate. The Federal Reserve, under those circumstances, has little choice other than to continue its recent tightening campaign, going well beyond the post-crisis normalization drill that was executed in 1999. Hence, we look for an additional 75 bps of Fed tightening in 2000, a hike that we think will be matched by the ECB and the Bank of England. With most of the world?s major central banks in a tightening mode, and with global growth tipping dramatically to the upside, it?s hard to look for any meaningful relief in global bond markets. We continue to believe that long rates are most at risk in the United States -- not just be-cause of the inflationary potential of fully employed labor markets but also because of the real interest rate pressures stemming from the external financing requirements of America?s record current account deficit. On that count, the sharp 25 bp back-up in real long-term interest rates that has occurred over the past five months (as measured in the 10-year TIPS market) bears special note. For the first time since the current bond market correction began a year ago, pressures are coming more from real rates than from inflationary expectations. Consequently, if US inflation risks tip to the upside, as we suspect, the back-up in nominal bond yields could be all the more acute. With the risks to bond yields skewed to the upside, pressure for a correction can only build on over-valued equity markets. And depending on the duration of the coming correction, the feedback effects into wealth-dependent real economies could be decisive in shaping the global macro climate in 2000. It is in that sense that global healing may well beget the fierier endgame that I have long feared. While the world economy appears to be on the cusp of two outstanding years, ever-exuberant financial markets may become increasingly intolerant of all this good news.