Roach & Berner
morganstanley.com.
two articles
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On the surface, commodity prices are flashing the same signal they did a decade ago. A two-year weakening of the dollar only reinforces the case for accelerating inflation. But there is a big difference on the labor cost front — instead of the modest increases that were evident in 1993-94, US unit labor costs were still contracting at a 1.7% annual rate as 2003 drew to a close. Consequently, with worker compensation accounting for fully 70% of total business production expenses, it’s hard to envision an outbreak of CPI-based inflation when labor costs are still declining so sharply. As was the case a decade ago, a burst of input inflation need not translate into a resurgence of retail inflation. Largely for that reason, but also mindful of the lack of pricing leverage in increasingly globalized markets, I sense another false alarm brewing on the US inflation front.
Yet that’s not a reason to let central banks off the hook. My concerns focus, instead, on the mounting risks of a very different type of inflation — inflation in the price of financial assets. In part, that’s because US monetary policy is actually more stimulative today than it was a decade ago. Back then, the real federal funds rate — the nominal rate less the headline CPI-based inflation rate — dipped only fractionally into negative territory, hitting a low of –0.2% in late 1993 and early 1994. In the current climate, the real federal funds rate went further into negative territory during the second half of 2002 and then held at an average of around –1.0% in 2003. By our calculation, the funds rate is still negative to the tune of nearly 100 basis points — a 1% nominal rate less a headline CPI inflation rate of 1.7%. The Fed has justified this extraordinary accommodation as necessary to contain the damage of America’s post-bubble shakeout (see Alan Greenspan’s January 3, 2004, speech, “Risk and Uncertainty in Monetary Policy,” presented at the Meetings of the American Economic Association in San Diego, California). But now, with the economy apparently in a solid recovery mode and the Fed projecting a 4.5% to 5.0% GDP growth pace over the four quarters of 2004, the case for unusual post-bubble accommodation can be drawn into serious question.
In my view, a central bank exit strategy from unusual monetary accommodation need not be tied to a pickup in CPI-based inflation. That’s especially the case if there is evidence of excessive stimulus spilling over into asset markets. To me, that’s precisely the message from the mother of all carry trades that has encouraged investors and speculators to redeploy “free money” available at the short end of the yield curve into a series of highly leveraged longer-duration bets. That’s true in a broad array of fixed-income assets — from Treasuries and mortgage-backed securities to investment-grade and high-yield corporate bonds. And that’s also the message from the US property market, where nationwide house price inflation surged at a 14.7% annual rate in 4Q03 — ending the year on an 8.0% y-o-y trajectory, close to a record high. Forget about the still-constructive call on CPI-based inflation. A failure by the Fed to implement an exit strategy only heightens the risk of a new wave of asset bubbles, in my view. The longer it waits to pull the trigger, the more painful the subsequent bursting will be. And the big risk, of course, is that a major asset bubble pops when the Fed is still locked into a 1% funds rate — a situation that would find the central bank with virtually no ammunition to deal with a post-bubble shakeout.
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Some clients are beginning to wonder whether 2004 will replay the bond-market bloodbath of 1994, given today’s low yield levels and the market’s recent strong reaction to the first sign of strong, if inconclusive, job growth. Few saw the 1994 debacle coming, as it followed a five-year rally in bonds. Between February and November of that year, 10-year Treasury yields jumped by 225 basis points (bp), and the decline in bond prices was a record for such a short period. I’m not a fan of numerology, so I don’t think bonds necessarily suffer in years ending with a 4. More important, there are many differences between today’s fundamentals and the then-prevailing economic and financial market backdrop. Consequently, at this juncture, nothing like 1994’s bond-market carnage seems likely. But there are also similarities between then and now, many of which support our bearish stance on bonds.
It’s worth remembering the sources of 1994’s debacle in bonds. The story isn’t simple, but for me three ingredients stand out among those that fueled the backup in yields. First, and perhaps most important, neither market participants nor the public at large understood that low inflation wasn’t low enough for a Fed bent on “opportunistic disinflation.” The Fed’s preemptive war on inflation was especially shocking, given that inflation and inflation expectations had both declined in the previous three years to 20-year lows with no sign of a quick rebound.
Today, two important differences in circumstances provide a more bullish backdrop for bonds. Most important, inflation is still too low for a Fed bent on “opportunistic reflation;” it is substantially lower than in late 1993, and global economic slack seemingly precludes a significant upturn. Today’s 1%-plus rate of core inflation is at the lower end of the Fed’s presumed 1-2% range; by comparison, core inflation stood at 2½-3%, depending on the metric. As a result, preemptive policy moves are unlikely; the Fed can afford to be reactive, rather than anticipatory, when it comes to making policy changes. In addition, consensus forecasts already anticipate hearty economic growth, so that outcome is likely in the price; today, bears are in the minority. For example, the median forecast in the Blue Chip survey is for 4.2% growth over the four quarters of 2004, and even the 10 most pessimistic forecasters expect 3.4% growth over the year. That would hardly qualify as a fragile outcome. |
