Stephen Roach: Running Out of Basis Points
<It’s hard to fathom the about-face of the Federal Reserve this year. I say that with the long-standing credentials of an out-of-consensus bear on the economy. When we first laid out our US recession call in early January, I was chided for my seemingly outrageous view that the US central bank would cut official rates by 300 bp. Well it’s now been 450 bp -- and still counting. The Fed has orchestrated the most aggressive monetary easing since the end of the 1973-75 recession, when it took the federal funds rate down from 13% to 5.5%. (Note: Since the inception of the data history back to 1954, the 70% decline in the funds rate which has occurred this year has only been exceeded in percentage terms during the August 1957 to July 58 period, when the overnight lending rate went from 3.5% to 0.75%). However, unlike the case of the mid-1970s, the authorities suddenly seem in danger of running out of ammunition. Just like Japan.
The Fed, in my view, has good reason to worry about this possibility. That’s especially the case if the US economy is suffering from much more than a garden-variety recession. If this was judged to be only a standard business cycle, the central bank would have long ago signaled its willingness to wait out the lags. Instead, the monetary authorities have moved with uncharacteristic haste. Ten rate cuts in eleven months, plus complicity in a surgical strike at the long end of the yield curve, underscore the gravity of the situation. Add to that the ongoing bias toward further monetary easing, and I don’t think it’s unfair to depict the actions of the Fed as bordering on institutional panic.
A lack of policy traction is, of course, the ultimate fear. It is the classic result of the dreaded "liquidity-trap" -- one that Japan knows all too well these days. If, indeed, the Fed is now facing a US economy that has suddenly become unresponsive to interest rates, there is a distinct possibility that it may end up spending most of its remaining basis points in futile attempts to restart the economy. That’s hardly the consensus view -- nor is it one embraced by our own US economics team. But I think there are five reasons to contemplate just such a possibility:
First, and foremost, the US economy is suffering the lingering aftershocks of a popped asset bubble. The liquidation of excess capacity -- both IT capital and white-collar labor -- remains an overriding objective of a cost-conscious Corporate America. The bloat of the New Economy must be taken out -- irrespective of the level of the overnight lending rate (see my 19 October dispatch, "The End of the New Economy").
Second, there are powerful global headwinds that lower domestic interest rates cannot contain. The world is in the midst of a rare synchronous recession. The first leg was triggered by an American-led downturn of the global IT cycle that pushed most of Asia into recession. The next leg has been triggered by the terrorist attacks of 11 September, which sparked the long overdue capitulation of the American consumer. As America has exported these two shocks to a US-dependent global economy, the rest of the world has gone down for the count. That, in turn, will impair US export prospects -- irrespective of the level of short-term interest rates.
Third, it may well be that the pipeline of monetary stimulus is a good deal emptier than the traditional lag structure might otherwise suggest (see my 31 October dispatch, "An Empty Pipeline?"). In today’s climate, the monetary policy transmission mechanism seems to be increasingly concentrated on home mortgage refinancing activity. In part, that’s because the other options -- capital spending and a surprisingly vibrant residential construction sector -- have been effectively closed off. But the refi cycle works with much shorter lags than the traditional response to lower borrowing costs. And, courtesy of Detroit’s zero-interest rate financing bonanza, auto demand has already seen its maximum monetary stimulus. To the extent the lags of Fed easing have already played out, the image of a pipeline brimming over with future support from this year’s aggressive monetary stimulus may be misplaced.
Fourth, history tells us that the perils of deflation are exceedingly difficult to overcome by monetary easing. In part, that’s because deflation makes a given nominal interest rate more onerous in real, or inflation-adjusted terms. With short-term nominal interest rates sticky at "zero," any whiff of deflation -- a distinct possibility, in my view -- could quickly find the US economy facing real borrowing rates that are simply too high to underwrite sustained economic recovery (see my 5 November dispatch, ‘Deflationary Risks Rising").
Fifth, a possible downshift in the productivity trend could also leave the US economy insensitive to lower interest rates. The federal funds rate is now back to levels that prevailed in the early 1960s -- just when the US economy was entering its first productivity-led boom. While it may be hard to prove this assertion, I believe that an economy on a path of accelerating productivity growth is more elastic and, therefore, more responsive to fiscal and monetary policy actions. Conversely, for an economy on a decelerating productivity trend, that same elasticity will be lacking. If the productivity boom of the late 1990s now unwinds, as I suspect, it could well be harder for policy initiatives to crack the armor.
All this speaks volumes of a US economy that could continue to frustrate the Federal Reserve in its noble mission to achieve policy traction. I have long suspected that the US central bank has a "stop point" on a 2% nominal federal funds rate. There’s nothing magical about that level -- especially since it may end up being surprisingly high in real terms. But when official rates enter the twilight zone of having a "one-handle," the fears of a Japanese style conundrum suddenly become very real. The last 200 bp of monetary easing is a very precious commodity -- one that no central bank would wish to spend, unless the circumstances were so dire it had no other choice. For the reasons enumerated above, that’s precisely the outcome I now fear.
Needless to say, this message doesn’t go over very well in investor circles these days. I often get queried in response, "So what would you do?" The problem is that economics provides no clean prescriptive remedy for an economy in a liquidity trap. The best the Fed can do, in my opinion, would be to surprise the markets with a more creative and aggressive easing -- something it has been either unwilling or unable to do this year. And it should accompany such an action with an explicit signal that it intends to maintain an exceedingly low level of official rates for an indefinite period of time. Quite frankly, I’m not even certain that would help, but I sure think it beats the current incremental approach.
One tough question begets another. And I would counter by asking the Fed why it allowed all this to happen in the first place. After all, this was the same central bank whose chairman warned of "irrational exuberance" in December 1996, when the Dow was at 6400 and the Nasdaq at 1300. But rather than deal with the perils that such speculative activity was bound to foster, we find that the Fed ended up rationalizing -- and tacitly encouraging -- the ensuing asset bubble by endorsing the untested and suspect theories of the New Economy. Unfortunately, when the bubble popped, the policy gambit was exposed. Almost any monetary easing would have then been too late. And now the Fed may have little choice other than to spend its remaining basis points.> |
