Global: Razor’s Edge
Stephen Roach (New York)
An unbalanced global economy is back on the razor’s edge. High oil prices are taking a toll on the US growth dynamic at precisely the point when a Fed tightening cycle has begun -- a risky combination by any standards. At the same time, a shift to policy austerity in China has led to a modest slowing of that overheated economy, with a good deal more to come. That puts a two-engine world -- driven by the American consumer on the demand side and the Chinese producer on the supply side -- in a zone of heightened vulnerability. As I see it, the risks on the downside outweigh those on the upside by a factor of three to one. I would now assign a 40% probability to a recessionary relapse in the global economy in 2005.
The Federal Reserve is in an excruciatingly difficult place. It’s hard to remember a time when the US central bank last tightened in the face of weakening data flow. But tighten it did, with a measured increase of another 25 basis points on August 10. Far be it for me to be overly critical of this action. After all, earlier this year, I publicly urged the Fed to be bold in executing a normalization of monetary policy by taking the federal funds rate from 1% to 3% in one fell swoop (see “An Open Letter to Alan Greenspan” originally published in the March 1 issue of Newsweek International). Alas, circumstances were very different six months ago. Oil prices were $10 lower and the US had an ample growth cushion. From my point of view, it was important for the US central bank to seize that moment and rebuild its depleted arsenal of policy weapons. Such an “opportunistic normalization” also would have served the useful purpose of unwinding carry trades and the multiple asset bubbles they spawn.
That was then. Suddenly, the US economy looks exceedingly vulnerable. An income- and saving-short American consumer, burdened by record debt levels, has been prompt to respond to sharply rising oil prices. Personal consumption expenditures rose at just a 1% annual rate (in real terms) in 2Q03 -- equaling the weakest increase since early 1995. The quick-trigger nature of this response is ample testament, in my view, to the underlying precariousness of consumer fundamentals. While the just-released July retail sales report points to a rebound in the third quarter, further increases in oil prices in the face of anemic job growth should temper any optimism. Moreover, I am starting to get worried about rapid inventory building in the face of this oil shock; in the three months ending June 2004, total stocks of manufacturing and trade establishments have risen at about a 9% average annual rate -- triple the growth rate of business sales over this same period. This borrows a page right out of the script of the summer of 1974, when the first OPEC shock led to an unwanted inventory overhang that blindsided the Fed and set the stage for severe recession in 1974-75. In short, the window has closed quickly on opportunistic normalization -- the growth cushion has all but vanished into thin air.
The Fed, of course, doesn’t see it that way. Its August 10 policy statement contained a very explicit forecast of better times ahead. Despite recent energy-related weakness, the FOMC maintained that “(t)he economy nevertheless appears poised to resume a stronger pace of expansion going forward.” It is very rare for America’s normally reticent monetary authorities to make such an explicit forecast of the future. Just out of curiosity, we combed the archives back to 1994 (when the Fed first began to release such policy statements) and came up with only one earlier instance when the FOMC was equally explicit in articulating a forecast. It was in June 2002, when America’s post-bubble recovery was flagging once again. The Fed’s press release after the June 26 meeting stated very clearly that “(t)he Committee expects the rate of increase of final demand to pick up over coming quarters.” Unfortunately, that was not one of the Fed’s better calls. Final demand growth averaged an anemic 1.3% (annualized) in the second half of 2002, and a year later the federal funds rate had been lowered from 1.75% to 1.0%. Oops.
As a bruised and battered forecaster, I have long refrained from taking shots at others who have chosen this noble profession. Eons ago, I was warned that “those who live in glass houses should never throw stones.” Fair point. But there are those who have taken great comfort from the Fed’s upbeat forecast that accompanied its latest policy action. My advice is to take that forecast with more than the usual grain of salt. Contrary to popular opinion, the Fed’s track record as a forecaster hardly puts it on a pedestal. The Fed is in the “soft patch” camp -- premised on the belief that a fundamentally sound US economy is only experiencing a temporary energy-related disruption. I hold the view that the US is fundamentally unsound -- increasingly vulnerable to the imbalances of its twin deficits, excessive household indebtedness, a record shortfall of national saving, and unusually anemic job creation and wage income generation. Only time will tell which forecast ends up being closer to the mark.
Meanwhile, on the other side of the world, the China slowdown continues apace. The just-released July data on industrial activity, trade flows, and bank lending are especially encouraging in that regard. But the progress on the road to a soft landing is still limited, at best. Industrial output growth has now slowed to 15.5% -- down from the peak comparisons of 19.4% in early 2004 but still well above the 8-10% growth channel that I believe will eventually be consistent with a soft landing. The import data were also on the soft side in July -- consistent with a moderating pace of domestic demand growth. However, while the 34.5% Y-o-Y comparison represents a moderation from the 50% spike in June, it is still vigorous by most standards and well in excess of the 20% pace that I believe would be more consistent with a soft landing. The credit data tell essentially the same story: July’s 15.5% Y-o-Y increase in bank lending is down from the nearly 20% surge in April but still well in excess of the 10% pace that would fit the slowdown scenario. In my view, growth in industrial output is the best way to judge the China slowdown. By this metric, the journey is now only about 40% complete (i.e., output growth has decelerated by only four of the ten percentage points it needs to attain a soft landing). In my view, significantly more slowing in the Chinese economy can be expected over the balance of this year and into early 2005.
With downside risks mounting in the world’s two main growth engines in the face of sharply rising energy prices, the case for global recession in 2005 must now be given serious consideration. In discussing this possibility with clients in recent days, many have asked whether other segments of the global economy could fill the void. Japan is the leading candidate in this regard, with hopes that its newfound vigor might spur a resurgence of pan-Asian growth. It’s a good story but I don’t buy it. Despite all the gushing enthusiasm over Japan, its heavy dependence on China raises a serious warning flag as the Chinese slowdown now unfolds. Japan’s just-reported broadly-based shortfall in 2Q04 GDP growth -- a 1.7% annualized increase versus consensus expectations of 4.2% -- underscores the fragility of the growth dynamic of an economy that is so heavily dependent on external demand. Our below-consensus 2005 forecast of 1.4% Japanese GDP growth suggests that the latest growth surprise may not be an aberration. The case for an Asian offset to weakness in the US and China is a weak one, in my view.
It didn’t have to be this way. But such are the perils of a post-bubble, US-centric world. I often get asked, What would you have done differently? The luxury of hindsight makes the answer to this tough question all too easy. But for me, it all hinges on the Fed’s repeated blunders in coping with asset bubbles -- first equities in the late 1990s and, more recently, property. Moreover, with a pegged currency, China’s property bubble is very much a by-product of the close conformity between US and Chinese monetary policies. The macro playbook is clear on what it takes to contain the damage of a post-bubble shakeout -- aggressive monetary easing. Yet the risk is that interest rates ultimately get pushed down so low that one bubble begets another -- thereby upping the ante in an already perilous endgame. Ultimately, interest-rate normalization is the only way to break this dangerous chain of events. And that takes us smack into the realm of heightened cyclical risk: If a policy realignment coincides with a negative shock, a fragile post-bubble shakeout can quickly morph into recession. Balanced on a razor’s edge, that’s precisely the risk as today’s bubble-prone, saving-short US economy now comes face-to-face with an energy shock.
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Mish comment
I believe we get interest rate "normalization".
It will take a form that no one expects.
Since I think we are in for a long period of disinflation, "normal interest rates" just might be right about where they are now.
In the UK and Euroland, I believe "normal" interest rates will be lower. Rising energy prices can not be combatted by raising interest rates if the reason for rising oil is structural. I believe rising oil is a combination of various factors: structural decline, hubberts peak, rising 3rd world demand, geopolitical concerns, failure to conserve, and failure to develop alternate energy resources. Raising interest rates will not affect the amount of heating oil one needs this winter, it will not affect the demands of gas guzzling SUVs (although it will affect the demands FOR gas guzzling SUVs), and it will not affect the amount used by utilility companies. With wages not keeping up with energy prices, but energy prices somewhat inelastic to interest rates, the FED is in a box with no way out. Recession 2005 seems more or less clear. The worldwide interest rate hikes for 2005 with the inventory buildups we have seen headed into a slowing economy are not likely to happen.
Mish |
