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Strategies & Market Trends : Mish's Global Economic Trend Analysis -- Ignore unavailable to you. Want to Upgrade?

To: THE ANT who wrote (24437)	2/25/2005 3:46:41 PM
From: Haim R. Branisteanu	Read Replies (1) \| Respond to of 116555

klaser, 1979 is not exactly recent history IMHO almost a generation apart <GG> - and you are welcome to make more comments on Brazil as I do not think that Mish will oppose and after all it is a GLOBAL board

To: THE ANT who wrote (24437)	2/25/2005 3:49:59 PM
From: mishedlo	Read Replies (1) \| Respond to of 116555

Global: The Instruments of Rebalancing Stephen Roach (from Basel, Switzerland) Global rebalancing does not occur spontaneously. It takes adjustments in economic policies and asset prices to spark a meaningful realignment in the mix of global growth. Shifts in currencies and real interest rates are the two major instruments of rebalancing. The ideal prescription for today’s lopsided US-centric world would be a combination of dollar weakness and a rise in US real interest rates. However, there is serious risk that the Fed will not execute the full-blown normalization of real interest rates that the US economy requires. If that’s the case, then there will be even greater pressure on currency adjustments to correct today’s imbalances — a development that could take world financial markets by great surprise. To date, progress on the road to global rebalancing has been dominated by currency adjustments — namely a 15% decline in the broad trade-value of the dollar (in real terms) over the past three years. Courtesy of the dollar’s decline, the US contribution to world GDP growth averaged only 16% over the 2003-04 period — down dramatically from the 98% share recorded over the 1995 to 2005 interval (all calculations expressed at market exchange rates). Rebalancing, however, entails far more than a realignment of the currencies that shape the world’s relative price structure. In the end, it will also require a narrowing of the growth differentials between the US and the rest of the world. So far, that hasn’t happened. While America’s share of global GDP growth has been on the wane, its 3.7% average GDP growth over 2003-04 remained two percentage points greater than the 1.7% average growth elsewhere in the industrial world — little different than the post-1995 growth spread. A narrowing of the growth spread between the US and the rest of the world is key for a resolution of America’s trade- and current-account imbalances. Currently, US imports are 52% larger than exports. Given the reduced currency elasticities of exports and imports that have been evident over the past decade — most likely an outgrowth of intensified globalization — my guess is that it would have to take at least another 30-40% drop in the broad dollar to get the job done. Quite simply, that would be an intolerable outcome for the rest of the world. Ultimately, the import content of the US trade deficit can only be reduced by a compression in the growth of domestic demand. And that’s where real interest rates come into play — as the primary instrument to temper the excesses of US domestic demand growth and the increasingly high import component of that demand. That takes us to the most critical juncture in the road to global rebalancing — the willingness of America’s Federal Reserve to raise real interest rates. Despite all its bluster, the Fed has actually accomplished very little in its interest rate normalization campaign. The nominal federal funds rate of 2.5% is still unacceptably low in real terms — negative when judged against the headline CPI (3.0%) and barely positive when measured against the core CPI (2.3%). Since the Fed began its measured tightening in June 2004, core inflation has moved up by 60 bps (from 1.7% in May 2004 to 2.3% in January 2005); that means the acceleration of inflation has offset fully 40% of the Fed’s 150 bp of nominal tightening that has occurred over the past seven months. Real short-term interest rates may not be as negative as the used to be, but they are still not all that different from zero. Six monetary tightenings later and the cost of overnight money remains basically free in real terms. We debate endlessly what the so-called “neutral” level of the real federal funds rate might actually be. Conceptually, this benchmark is the functional equivalent of the policy rate that imparts neither ease nor restriction on the real economy — a rate that would effectively hold inflation steady. By all current indications — the ongoing strength in the economy to say nothing of the profusion of Fed-sponsored carry trades in a multitude of risky assets, as well as an acceleration of core inflation — US monetary policy remains highly accommodative. My own take is that neutrality is somewhere in the 2-3% zone for the real federal funds rate — consistent with a conclusion that Dick Berner reaches in his dispatch in today’s Forum. That implies that the Fed has considerable work to do before completing its normalization campaign. The issue is not whether the Fed should take the funds rate back to its neutral setting — or even into the restrictive zone if it wishes to cool the economy. That is imperative, in my view. The question is whether the Fed will engineer such a tightening. As much as I hate to say it, I do not think that this Fed has either the courage or the political will to pull off such a maneuver. The logic hinges on my belief that the Fed has thrown its full weight of support behind the Asset Economy — an economy that is built on a false foundation of unsustainably low real interest rates. Accordingly, I also believe that both the real economy and financial markets are hyper-sensitive to increases in positive real rates. Not only would that pose great risk to residential property markets and the refi bonanza that supports income-short American consumers, but it would take away the “candy” of the carry trade — possibly leading to a sharp widening of extremely low spreads in corporate bonds, high-yield securities, and/or even emerging-market debt. As we saw all too painfully in 1994-95, an unwinding of these carry trades from multi-year lows is not without serious consequences in the investor, speculator, and borrowing community. In my view, systemic risk has built up dramatically during the low real interest rate regime of the past three years. A Fed that changes the rules of the game would have to confront that risk head on — not just in the in the form of a shell-shocked American consumer but also in the context of a potentially wrenching unwinding of carry trades that could well impart collateral damage on the US and other economies. This Fed is overly sensitive to political and market feedback and, in my view, not up to the time-honored independent role of being the tough guy and taking away that proverbial “punchbowl just when the party is getting good.” I fear at the first sign of weakness in the US economy or at the first hint of pyrotechnics in the financial markets, the Fed will flinch and abort its normalization campaign. The bottom line could be a real shocker. I continue to believe that global imbalances will be vented one way or another. My hope is that this venting would take place through a combination of both currency and real interest rate adjustments. To the extent that the real rate adjustment is curtailed, the currency realignment would then have to pick up the slack. This underscores the distinct possibility of another sharp downleg in the dollar. The greenback could be expected to decline not just against Asian currencies (both yen and Chinese RMB) but also further against the euro as well — especially if Eric Chaney and I are right on the possibility of US-European productivity convergence. Most, including our own currency team, believe that the dollar has fallen enough. However, to the extent that the real interest rate adjustment is curtailed, the risk is that there could be a good deal more to come on the currency front. Needless to say, currency adjustments don’t occur in isolation. Another sharp downdraft in the dollar could well lead to a flight out of dollar-denominated assets — or, at a minimum, a significant diversification of official foreign exchange reserves out of dollars. Asian central banks are already hinting at such adjustments to reserve portfolios. My guess is that at all it would take would be another protracted period of dollar weakness to trigger such diversification campaigns in earnest. Absent dollar buying either from private or official channels, US real interest rates would then have to rise as they normally do in a current-account adjustment. And the asset-dependent US consumer would suffer the same consequences outlined above, as would those involved in carry trades. In other words, a Fed that shies away from interest rate normalization will probably not be able to forestall the painful endgame that ultimately waits an unbalanced world. I continue to believe that an unbalanced world is in serious need of rebalancing. It was never going to be an easy task. Currency adjustments cannot do the job alone. An adjustment in real interest rates is a long overdue and essential piece of the rebalancing equation. If the Federal Reserve isn’t up to the task, financial markets will then take matters into their own hands. That’s when it could get really messy. morganstanley.com