from: http://www.aci.net/kalliste/ Click Here: <A HREF="http://www.aci.net/kalliste/">The Home Page of J. Orlin Grabbe</A> ----- Federal Reserve What a Friend We Have in Greenspan And Jimmy Buffet is Warren Buffet's son. While America’s Federal Reserve seeks to coax the economy down to a soft landing, the rest of the world worries about the risk of a sharper downturn AS THE Fed’s open-markets committee met this week, almost all those shouting advice from the sidelines agreed on what its aims should be. Clearly, if a rise in inflation is to be averted, the American economy has to slow from the breakneck pace it has kept up over the past couple of years. But that is where agreement ends. There is fierce debate over what form a slowdown might take: a soft landing—as the stockmarket is now betting—or a hard one. Foreign policymakers as well as investors have their fingers crossed, hoping it will turn out to be the first. The Fed’s decision on June 28th to leave its “fed funds” rate unchanged at 6.5% followed recent evidence that the economy was slowing already; and, despite a renewed warning of mounting inflationary pressures, this suggests it believes America is now on course for a soft landing. The Fed may have only one more chance—in August—to raise rates again before the election campaign poses political obstacles to such a move. Policymakers across the globe will be praying that Alan Greenspan, the Fed’s chairman, has got it right. America has accounted for almost three-quarters of the total increase in output among the rich economies over the past three years. So, at best, they will have to cope with the consequences of a slowdown: the motor of the world economy purring less irresistibly than before. At worst, they will have to deal with the after-effects of a crunching halt. Channel conflict What most people have in mind when they talk about a “soft landing” is a situation in which American interest rates do not need to go much higher to forestall inflation, and GDP growth slows, from an annual rate of over 5% in the first quarter of this year, to a rate of perhaps 2.5-3% next year, a shade below the rate that most people now believe to be sustainable in America. A “hard landing” generally means a recession—not necessarily a severe one, but at least two consecutive quarters of declining GDP—which might be combined with a sharp slide in both equity prices and the dollar. This is, of course, an oversimplification: in between “soft” and “hard” lie a whole range of landings of varying degrees of bumpiness. Or, as one fund manager put it, helpfully, “I expect a soft landing, but it could be the hardest we’ve seen for a long time.” Any glee overseas at seeing American economic hubris dented by a crash would be short-lived. There are three channels through which a downturn in America might harm other economies: trade, exchange rates and capital flows. As America’s economy has boomed, it has sucked in ever more imports, which have recorded an average annual increase of 12% in volume over the past couple of years, growing twice as fast as total world trade. This has been a key source of growth to economies stretching from Europe to Asia. But if America’s economy stalls, past experience suggests that import growth will fall more sharply than GDP. Even a soft landing in America would make it less attractive as an export market. The chart [not shown] identifies some of the economies that are most dependent on America. Top of the list are Canada and Mexico, which both send more than four-fifths of their exports to America, equivalent to 33% and 21% respectively of their GDPs. Several East Asian economies, such as Malaysia, the Philippines and Thailand, also export 10% or more of their GDPs to America. In contrast, in Japan and Western Europe the proportion is around only 3% of their GDPs, so the direct impact of a fall in exports to America would be modest. Take Germany; its exports to America rose by about 10% in volume last year. Suppose export growth fell to zero next year, as a result of a sharp slowdown in America. That would shave Germany’s GDP growth by only 0.3 of a percentage point. A similar slump in American import growth would lop a full percentage point off growth in Thailand and two points off Mexico’s. Painful, but not enough by itself to drag them into recession. If America’s economy had faltered two years ago, in the midst of the Asian crisis, the results would have been worse. But domestic demand is now recovering in the crisis-hit tigers, growing by 7% in South Korea last year. Another mitigating factor is that trade within the Asian region has been growing even faster than exports to America. A second channel for communicating American economic ill-health is the exchange rate. A hard landing in America might bring a sharp fall in the dollar against the other main currencies. Even a gentler slowdown might lead to a stronger yen and euro. That would further squeeze exports from Japan and Europe, already depressed by slowing growth in American demand. In contrast, sterling tends to move more in line with the dollar and so is likely to fall against the euro, helping exports. A further sharp rise in the yen could damage Japan’s exports and hence its fragile economy. The good news for the rest of East Asia is that currencies are still cheap compared with other emerging economies’. A stronger yen would make them even more competitive. The third source of contagion from America to the rest of the world is through stockmarkets. At present, Wall Street seems confident that a controlled slowdown is in the offing. Even that, however, implies slower growth in corporate profits, and hence a moderation in current sky-high share valuations. But many policymakers around the world remain worried about an American stockmarket crash. At least initially, that is likely to bring down markets everywhere, and to slow the flow of capital to emerging economies, as panicky investors opt for safer havens. Emerging economies with large current-account deficits and high debt-service burdens are most vulnerable. This means, in particular, Latin America, which the IMF expects to run a current-account deficit this year totalling $60 billion. A forthcoming analysis by American Express Bank considers in detail the global consequences of hard and soft landings in America. It reckons that there is still a 40% probability of a hard landing. Although any sort of slowdown in America would reduce other countries’ exports, John Calverley, the bank’s chief economist, argues that this could in theory be offset by stronger domestic demand. An American slowdown would reduce global inflation and cause other currencies to rise against the dollar, allowing central banks elsewhere to cut interest rates to boost domestic spending. The European Central Bank and the Bank of England would have ample scope to cut interest rates. As a region, therefore, Europe is well-placed to ride out an American downturn. The only doubt is whether hawkish central bankers would cut interest rates quickly enough. Japan, on the other hand, is more worrying, because its economy is still so sickly. Japan’s real GDP may have grown at an annual rate of 10% in the first quarter, but Japanese statistics are erratic and output could stall again in the second quarter. Prices continue to fall, so in money terms GDP in the firs t quarter was still lower than a year earlier. Most serious of all, unlike other central banks, the Bank of Japan cannot cut interest rates further, because they are already close to zero. There is a risk, therefore, that an American slowdown might push Japan back into recession. Could a sharper deceleration in America trigger another emerging-market crisis? Probably not. Some economies would be hurt, but overall most emerging economies are in better shape than a couple of years ago, with large foreign-exchange reserves, and floating, not fixed exchange rates, making it easier for economies to adjust. The implications of a slower-growing America economy thus vary around the globe. But even in the euro area, which seems to have least to fear, the outcome would be less happy if central bankers make mistakes and fail to ease policy until it is too late. 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