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Pastimes : All Clowns Must Be Destroyed -- Ignore unavailable to you. Want to Upgrade?

To: pater tenebrarum who wrote (34263)	5/22/2000 11:51:00 AM
From: Crimson Ghost	Read Replies (2) \| Respond to of 42523

Morgan Stanley says: Don't Fight the Fed Stephen Roach (New York) While the implications of the New Fed are starting to sink in, investors are still shaking their heads in disbelief and denial. Hope springs eternal that the central bank need not go much further in its tightening campaign. Four considerations are most frequently cited in this regard: First, the Fed may have already done enough; on the heels of slowing money growth and 175 bps of tightening over the past 11 months, why shouldn't the central bank now simply sit back and let the lags play out? Second, an aggressive Fed tightening might trigger a devastating asymmetrical wealth effect that could wreak havoc on the US and the global economy. Third, inflation is dead; globalization and the Internet suggest that the Fed is fighting the last war. Fourth, such a policy gambit could give rise to another global crisis. Why should the Federal Reserve tempt fate and attempt to bring the US economy in for an always-perilous soft landing? First, there is little reason to believe that the Fed has done enough. It's main policy metric remains the inflation-adjusted, or real, federal funds rate. With the nominal funds rate now at 6.5% and annualized CPI-based inflation holding at 3.0%, the real federal funds rate currently stands at 3.5%. That's only 50 bp above the longer-term average, or neutrality benchmark. That means that courtesy of the May 16 tightening, the real funds rate has only just been pushed into the restrictive zone. For a fully employed US economy that has been on a 4.5% growth tear over the past four years, there are hardly grounds to argue that the Fed has gone far enough. By contrast, there is a more compelling argument that it may have only just begun. Nor should the Fed be dissuaded from its mission by the recent deceleration in money supply growth. Yes, growth in the broad money supply as measured by M2 has slowed to a 5.3% y-o-y rate in May; while that's down from the 9%-plus pace of late last year, this deceleration means little for a Fed that has long given up on monetary targeting. Given the co-mingling of transactions and savings balances, fluctuations in the US money supply have long been dominated by portfolio shifts stemming from variations in interest rates. In a rising rate climate, the interest-sensitive portion of the monetary aggregates typically slows as deposits are shifted into higher-yielding instruments that are outside the scope of M2. For that reason, alone, the Fed has long de-emphasized monetary targeting and focused, instead, on the real short-term interest rate metric. Consequently, there are no actionable policy implications that can be drawn from the recent deceleration in money supply growth. Fear of a devastating asymmetrical wealth effect is a second consideration that many cite as reason for the Fed to limit its interest rate assault. The corollary of this thesis is that the Fed will reverse course and quickly ease should the US stock market fall sharply further. Barring an outright crash in the broader equity market indexes, I believe that the Fed will err on the side of demonstrating that it is not a slave of the stock market; needless to say, with the Wilshire 5000 still holding about 4.7% above its year-earlier level, the Fed is still far from such a predicament. Nevertheless, if the Fed were to flinch at the first sign of broad-based investor distress, it would be guilty of the classic moral hazard critique - demonstrating that it truly believed that the US equity market had become "too big to fail." In that case, the dip buyers would quickly re-enter with a vengeance, adding further impetus to a wealth effect that the Fed believes has been boosting US GDP growth by about one percentage point per year for the past five years. Given its concerns about an intensification of cyclical pressures in the US economy, the Fed can hardly afford to unleash yet another surge in the stock market. The presumed death of inflation is widely cited as a third reason why the Fed need not go any further. The problem with this line of reasoning, in my view, is that it confuses secular analytics of the New paradigm with a cyclical story. Globalization and the Internet are mega-trends, to be sure. But they do not render the laws of supply and demand obsolete as dominant forces shaping cyclical fluctuations in inflation. A rapidly growing US economy has crashed through the threshold of full employment; if left unchecked, this growth surge could lead to a serious condition of cyclical overheating. The recent acceleration of wages and the core CPI are early warning signs that such a dynamic is now emerging; potential downside risks to the dollar and productivity growth underscore the potential for a further intensification of cyclical inflation. While these forces to do not challenge the secular trend of disinflation, they underscore the need for the Fed to limit the cyclical pressures before they get more entrenched and do damage to the secular story. Fourth, and finally, it would be the height of folly if the Fed were to be gun-shy because of the painful memories of the global financial crisis of 1997-98. Financial crisis can, and do, happen. The last one was hardly the end of this chain of events. But the world has learned some important lessons in the past few years, and has finally begun the long and arduous process of implementing the structural reforms that may temper the inevitable next crisis. Asia's elimination of currency pegs was an important step in this regard - as was the region's more recent establishment of a 13-country currency swap network, backed by over $700 billion in foreign exchange reserves. Reforms have continued apace in Latin America, and even Russia and is starting to get back on its feet. Yes, the Fed must be vigilant on the crisis watch. But it cannot afford to compromise the imperatives of a domestically focused monetary policy for an event that currently seems distant and remote. There's nothing warm and fuzzy about the Fed's mission. Former Fed chairman, William McChesney Martin put it best when he quipped decades ago that the central bank's toughest job is to "take the punch bowl away just when the party is getting good." This is one of those times. The Fed's script is a simple one - to keep tightening until it becomes convinced that the medicine is working. It's a task that requires focus and discipline. And my guess is that it is a task that has only just begun. Don't figh