ONE ECONOMY, TWO WORRIES
Welcome to the age of disconnect, divergence and disagreement. In one corner, we have those who worry about falling rates of inflation, perhaps leading to deflation. Among the believers: none other than our own Federal Reserve, which announced this past Tuesday, after deciding to hold interest rates steady, that "on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future." The price of money, in sum, isn't about to rise any time soon.
That is, if Greenspan and company have anything to say about the price of money. And they do…to a point, and primarily on the short end of the yield curve. As for the long end, well, that's a domain subjugated by Mr. Market, who isn't necessarily in agreement with the folks at the Fed, or anyone else for that matter.
Since the central bank decided to cut Fed funds by 25 basis points on June 25--instead of the 50 basis points that many expected--the yield on the benchmark 10-year Treasury has soared, from about 3.4% to 4.6%. Thus the disconnect we mentioned above. Greenspan, Fed Governor Bernanke, et. al. are talking up deflation's potential as the new world order of finance risk while Mr. Market frets over the reverse monster known as inflation and so demands a higher risk premium for holding the Treasury's bonds.
Bill Gross, the guru bond manager who oversees the world's biggest portfolio of fixed-income instruments at PIMCO, worries in his latest investment outlook that "yields are extremely low on an inflation-adjusted basis. In addition, bond prices and therefore total returns are at risk if reflation takes hold or – heaven forbid, if foreign creditors begin to unload their sizeable holdings." All of which convinces him to buy TIPS, or inflation-indexed Treasuries.
The question that weighs on us is why the Federal Reserve doesn't share Gross's apprehension? Could it be that the central bank knows something the rest of us don't? That's always a possibility when you're talking about an institution that is effectively judge and jury when it comes to setting the number of dollars in circulation. So, why fight the Fed? The economics team of Paul Kasriel and Asha Bangalore at Northern Trust says you shouldn't. That is, "unless you firmly expect a massive run on the dollar and/or sharply higher inflation between now and mid 2005…."
What constitutes a "firm" conviction is open to debate, but the economic data is there for everyone to digest as he or she sees fit. M2 money supply, for example, is advancing on a year-over-year basis at 8%, while the economy chugs along at 2.4%, based on the latest GDP report. Inflationary?
As for the prospects of a dollar crisis, it may or may not occur, but even if one seems imminent there's a lot less consensus than you'd think on what the potential impact could be. First, consider a recent interview with Richard Duncan, author of the new book The Dollar Crisis. "It is the imbalances in the international trade system rather than the system itself that poses the danger," Duncan tells Christopher Runckel via Business-In-Asia.com. "The United States’ current account deficit," Duncan continues,
is now $60 million an hour! It increased 28% in 2002 to half a trillion dollars, an amount roughly equivalent to 5% of US GDP. This unprecedented trade imbalance has created extraordinary disequilibrium in the global economy. The countries that build up large stockpiles of international reserves due to large current account or financial account surpluses—such as Japan in the 1980, the Asia Crisis countries in the 1990s and China today—develop bubble economies. When those bubbles pop, as they inevitably do, they leave behind banking crises and excess capacity. The governments of those countries must then go deeply into debt to bail out the depositors of the failed banks. At the same time, the excess capacity in the economy results in deflation. Economic bubbles and systemic banking crises can be expected to reoccur and deflationary pressure can be expected to persist so long as the US current account deficits continue to flood the world with dollar liquidity.
Duncan is clearly worried about deflationary threats from a dollar crisis. Apparently, the Fed shares that view. To the extent such pressures will offset the Fed's reflation policy remains to be seen. For the moment, Mr. Market seems to think the Fed will win, and inflation will dominate. Kasriel and Bangalore share that view, noting the central bank "will be successful over the next 10 years" in raising inflation.
The Northern Trust team finds reason to worry over the dollar too: "It is beyond us why the rest of the world willingly advances the U.S. $1-1/2 billion a day to buy bigger cars, bigger houses, and cruise missiles, especially in light of the Federal Reserve pledging that these foreign investors will be paid back with U.S. dollars that will be worth less in the future." The outcome, they conclude, is higher inflation. "A run on the dollar would cause our inflation rate to rise faster than otherwise and would put the Fed in the position of having to raise the funds rate more aggressively than otherwise."
Even when looking at the same risk, minds will differ on the outcome. Let's review. A dollar crisis will lead to a) deflation or b) inflation? Depends on who you talk to. You say tomato, I say to-mah-to.
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