By the looks of it, Roach is on our side too but of course there is nothing new about this.
Apparently, we are all waiting for Godot but I am sure of that he will show up one day. If only I knew when and whether I would be around to meet him. Sabri +++++++++++++ Heading for the Exits Stephen Roach (New York) Global Economic Forum, June 18, 2004 First, it was the Reserve Bank of Australia. Then, the Bank of England. And now, it's the Swiss National Bank. One by one, central banks around the world are joining the rush to the exit doors. So far, the Big Three - the Federal Reserve, the ECB, and the Bank of Japan - have yet to embark on the road to policy normalization. But that day is coming - and the sooner the better, in my view. Now, more than ever, the global economy and world financial markets need to be weaned from the steroids of extraordinary monetary stimulus. Coming from me, of course, that sounds like a broken record. Earlier this year, I urged the Fed to turn aggressive in normalizing its policy stance by moving the federal funds rate in one step from 1% to 3% (see "An Open Letter to Alan Greenspan" published in the March 1, 2004, issue of Newsweek International). While my suggestion was not exactly well received at the time, the markets are now rife with talk of the need for a bold policy adjustment. Even the Fed is waffling on this point. One minute, senior Fed officials cling to the incrementalism of a "measured" tightening. The next minute, they go out of their way to distance themselves from such a mechanistic approach. Little wonder, fixed income markets go back and forth in discounting the outcome of the upcoming FOMC meeting on June 29-30. In the heat of debate, it's easy to fixate on the high-frequency economic statistics that often seem so decisive in shaping the tactical outcome. In doing so, however, we can lose sight of the big-picture issues that matter most. That point was hammered home to me recently by Hans Tietmeyer, former president of the Deutsche Bundesbank and a guest speaker at our mid-June European investment conference. Like America's Paul Volcker, Tietmeyer was a disciplined, tough-minded, and independent central banker. Under his leadership in the 1990s, the Bundesbank became one of the most credible central banks in the world. Tietmeyer was the personification of that credibility. And in listening to him last week, I couldn't help but sense his mounting concern over the current state of central banking. As I stressed in my summary of our Eden Roc conference, Hans Tietmeyer was clearly uncomfortable over the current degree of monetary stimulus that still exists in today's increasingly robust economic climate (see my June 14 essay in the Global Economic Forum, "Escape Act"). While he concurs that the emergency of last year's deflation scare may well have justified extraordinary monetary accommodation, he was equally quick to suggest that the excess stimulus must be removed promptly once the emergency is over. With world GDP growth having surged at a 5-5.5% annual rate over the past three quarters and core inflation rates having moved up significantly from their lows, the emergency has clearly passed. In Teitmeyer's view, a failure to remove excess monetary stimulus under these conditions underscores the risks of inflation, financial instability, and speculative trading activity in financial markets (i.e., the carry trade). There was one key point that stuck in my mind as I pondered the Tietmeyer message - his emphasis on a much broader concept of inflationary risks than one normally hears. In his view, inflationary pressures in both the real economy and asset markets must be taken into consideration. That's especially true when nominal interest rates converge on the zero-boundary, as they are doing at present. The transmission mechanism of a blunt policy instrument is very different at low interest rates than it is when rates are higher. It may well be that the excess liquidity of extraordinary stimulus doesn't impact inflation in the real economy; limited pricing leverage in the face of serious global competition could keep CPI-based inflation at bay for some time to come. If that's the case, then it seems perfectly reasonable to presume that the impacts of policy stimulus would then spill over into asset markets. And that, of course, is where the carry trade comes into play - the yield-curve arbitrage that creates an artificial bid for long-duration assets such as stocks, bonds, or property. On this key point, Tietmeyer is in strong agreement with Ottmar Issing of the ECB, who has argued that while asset markets should not be targeted by central banks, benign neglect is not the appropriate answer either (see Issing's February 18, 2004, editorial feature in the Wall Street Journal, "Money and Credit"). Tietmeyer underscored the related point that central banks should not contribute to market euphoria by talking up the fundamentals that may influence asset prices. Specifically, he warned that asset markets couldn't be neglected just because productivity growth is strong. In central banking circles, these are very strong words. Hans Tietmeyer made his reputation as a central banker by fixating on the linkage between monetary expansion and CPI-based inflation. Nothing else seemed to matter at the time. But now he is saying something quite different. Over the long sweep of economic history, asset bubbles pose the greatest perils of all. Mindful of the devastating risks of a post-bubble unwinding of excess debt, Tietmeyer is arguing that there are times when central bankers must think out of the box. And this, in his view, is one of those rare times. He expressed serious reservations about the Greenspan approach of acting only after a bubble bursts. He believes that's taking an unnecessary chance with what could end up being the biggest problem of all. In this climate, he stressed, "there is no simple dividing line between inflation and deflation." Interestingly enough, both the Reserve Bank of Australia and the Bank of England have been explicit in recognizing these pitfalls, especially in the context of overheated property markets. America's Federal Reserve is alone in denying the importance of asset markets in the conduct of monetary policy. Tietmeyer left little doubt as to where he came out on this key issue. I have belabored this point because I continue to believe that it may well be the defining macro issue of our time. Memories are short in these event-driven markets. But it was only a little over four years ago when America's biggest asset bubble in 70 years popped. It took the most aggressive combination of fiscal and monetary stimulus on record to prevent the post-bubble shakeout from morphing into outright deflation. Now that these policies have achieved cyclical traction, the extraordinary stimulus needs to be taken off. This has proved to be an extremely daunting challenge for central banks. The Bank of Japan attempted to wean a post-bubble Japanese economy from zero interest rates in August 2000, and the economy immediately lapsed back into recession and deflation. Now it's the Fed's turn. The problem in this case is that America's post-bubble workout has been financed on a mountain of debt. That's true of the household and government sectors and is also true in the external (i.e., offshore) borrowing required by a saving-short US economy. With debt ratios high, debt service ratios near the upper end of historical experience, exposure to floating rate liabilities on the rise, and the current account deficit in record territory, the US economy is highly sensitive to the impacts of the higher interest rates that a normalization of Fed policy will bring. To the extent these risks constrain the Fed to a glacial normalization, the greater the moral hazard and the greater the potential for new asset bubbles. Meanwhile, inflation is now moving up from its lows. That means with the Fed doing nothing - or moving with the incrementalism implied by the measured-tightening paradigm - a further decline in the real federal funds rate occurs. For a federal funds rate that is deeper into negative territory than at any point since the late 1970s, that is a serious matter. Such an outcome only heightens the monetary stimulus, thereby compounding the exit conundrum for the Federal Reserve. In retrospect, the anti-deflation drill was easy. However, now that the risks of deflation have diminished, the authorities need to restore policy settings to some semblance of normalcy. Since economies tend to acclimate themselves quickly to post-bubble policies, such normalization won't be an easy task to pull off. The sage advice of Hans Tietmeyer is worth noting in this regard. Not only does he warn of the perils of excess stimulus, but he also urges that the extraordinary accommodation be lifted sooner rather than later. It takes real courage to implement such an exit strategy. In the end, is there any other choice?
