World on the Mend
May 01, 2006
Stephen Roach (New York)
It seems like eternity since I was last optimistic on the world economy. It was back in 1999 when I argued that “Global Healing” would allow the world to make a stunning comeback from the ravages of the worst financial crisis in 60 years. My enthusiasm was short-lived, however, as the cure led to the mother of all liquidity cycles, multiple asset bubbles, and an unprecedented build-up of global imbalances. While an unbalanced world has yet to shake its hangover from global healing, I must confess that I am now feeling better about the prognosis for the world economy for the first time in ages.
The reason: The world is finally taking its medicine -- or at least considering the possibility of doing so. Central banks are carefully adjusting the liquidity spigot -- taking advantage of the luxury of low inflation to move very slowly in doing so. This delicate normalization procedure is necessary to prevent wrenching financial market crashes that would spell curtains for an asset-dependent world. Meanwhile, the stewards of globalization -- especially the G-7 and the IMF -- have finally come to grips with the imperatives of facing up to the perils of global imbalances. They are now hard at work in developing a multilateral solution to a multi-economy problem. At the same time, orderly currency adjustments appear to have resumed -- and this time, in the right direction. Ever so slowly, the dollar is being managed lower -- in keeping with the relative price shift that a long-overdue US current account adjustment needs. As always, there are still plenty of serious risks -- especially oil, geopolitics, fiscal paralysis, and protectionism. But the world now appears to be getting its act together, and that encourages me. Central banks remain leading actors in this drama. They almost blew it -- especially the monetary authorities in Japan and the US. By condoning asset bubbles and their concomitant distortions of debt cycles and increasingly asset-dependent real economies, both the BOJ and the Fed flirted with the most corrosive of macro diseases -- deflation. Japan actually succumbed to a mild, yet protracted, strain of this ailment, while the US had a close brush in 2003. The Fed studied the lessons of the Japanese experience carefully and made every effort to avoid a similar fate for the US (see A. G. Ahearne et al., “Preventing Deflation: Lessons From Japan's Experience in the 1990s,” Federal Reserve International Discussion Paper, June 2002). While Japan finally seems to be exiting from its long slump, the jury is still out in America, as one bubble (equities) has morphed into another (housing). Central banks have been aided in their post-bubble tactics by an unexpected ally -- a persistent disinflation. Courtesy of a rapidly spreading globalization of both tradable manufactured activity and once nontradable services, powerful structural headwinds have dampened inflationary pressures that might have normally arisen from a cyclical recovery in the world economy. This has provided monetary authorities with the luxury of moving slowly in weaning economies from their post-bubble medicine. Had inflation responded more to the traditional pressures of the closed economy -- namely, domestic unemployment rates and capacity utilization rates -- monetary policy would have been forced into a more activist post-bubble tightening mode. Instead, the ongoing disinflation of increasingly open economies has transformed the role of central banks. Rather than playing the destabilizing function of leaning against the inflation cycle, the authorities have been given license to focus more on a goal of “normalization” -- seeking to put policy rates on a neutral setting that is neither too tight nor too easy. This has reduced the possibility that the world will be disrupted by the boom-bust cycles that frequently plagued the economy of yesteryear. This is a delicate operation, to say the least. We are in the midst of what could well be the mother of all liquidity cycles. Courtesy of an extraordinary monetary accommodation, financial markets have enjoyed open-ended support from central banks. This has been a key role reversal for the tough guys who are supposed to take away the “punch bowl” just when the party gets good. Given the power of this liquidity cycle -- evidenced not just by asset bubbles in major markets but also by an extraordinary compression of spreads on risky assets such as emerging-market debt and more traditional credit instruments -- a serious monetary tightening could prove devastating for financial markets and increasingly wealth-dependent economies. As long as inflation remains low, however, the authorities can set their sights on the more benign target of neutrality. The latest downside surprise on the US inflation front -- another weaker-than-expected increase in the all-important Employment Cost Index -- provides support for that strategy. Despite a tightening labor market, compensation growth for civilian workers slowed to just 2.8% in the 12 months ending March 2006 -- down one full percentage point from the pace two years ago. This is yet another example of the power of the global labor arbitrage and good reason to believe that central banks can stay focused on the goal of normalization rather than tightening. The good news is that all of the world’s major central banks are now on the road to normalization. America’s Fed is furthest along in this process, and is now sending signals that this interim goal may be in sight. The ECB is not that far behind; since it was not forced into an emergency bubble-defense drill, it does not have that far to go to take its policy stance to a neutral setting — even though it has only tightened twice in the past five months. The Bank of Japan is now very much into the normalization drill; its latest upgrade of the economic outlook has promoted our BOJ watchers to put a 90% probability on a rate hike in either June or July (see Takehiro Sato’s 28 April dispatch, “Japan: Rosy Scenario, Rate Hike Sooner”). Even the People’s Bank of China has joined the ranks with its first rate hike in a year and a half; in my view, this is likely to be the first of several steps Chinese authorities will take in order to rein in the excesses of their liquidity cycle. In all of these cases -- the US, Europe, Japan, and China -- inflationary pressures remain well contained. That allows central banks in each of these economies to follow the Fed’s template of “measured” normalization -- balancing the limited risks of inflation against the more serious risks of a major about-face to liquidity cycles. The authorities are, in effect, taking a calculated pro-growth risk for an asset-dependent global economy. Against this backdrop, the recent breakthrough in long-dormant efforts to reform the international financial architecture is especially encouraging. Don’t get me wrong -- I am still very concerned about the mounting pressures of unprecedented global imbalances. America’s massive current account deficit -- hitting an annualized $900 billion in late 2005 -- puts an extraordinary financing burden on the world. Moreover, with the three largest surplus nations -- Japan, Germany, and China -- all hard at work in stimulating internal demand, America is likely to have less surplus foreign saving at its disposal. With the perils of a US current account adjustment mounting, global authorities had seemed asleep at the switch. That is no longer the case. I am pleased that they have risen to the occasion -- not just by devoting a special annex of the recent G-7 communiqué to global imbalances, but also by empowering the IMF to expand its purview to multilateral surveillance and consultations. That finally puts teeth into the global rebalancing campaign (see my 28 April dispatch, “Rebalancing Legitimized!”). While that doesn’t eliminate the possibility of a disruptive US current account adjustment, it does mean that an unbalanced world is now taking its collective responsibility more seriously. The wheels of global adjustment turn very slowly. But at least they do appear to be turning. The dollar is moving lower again after a 15-month hiatus from a multi-year decline that began in early 2002. Like Stephen Li Jen, I am not a believer that a weaker dollar is the cure for global imbalances. But I certainly don’t buy the new-paradigm rhetoric of a newly symbiotic world that is built on a foundation of ever-mounting imbalances and a strengthening dollar. By contrast, I view dollar depreciation as part of the solution for America’s excess consumption problem. Another important part of that solution is the end of the US housing bubble and the wealth-dependent excesses of consumer demand this bubble has supported. For that reason, I am also encouraged that the froth now seems to be coming out of the US housing market; recent blips in the monthly data on home sales run against this conclusion, but the trend has been decidedly lower since last summer. Moreover, the latest data on the Employment Cost Index underscores a persistent deficiency on the labor income side of the equation. Consequently, as the wealth effects from asset bubbles fade, I continue to believe that pressures will build on income-short American consumers -- setting in motion the only realistic fix to America’s gaping current account deficit. Finally, I am encouraged by what I see elsewhere in the world. I have just returned from my second trip to Asia in the past month, and I sense a major change in the region’s global perspective. That’s especially the case in China, where the need to stimulate internal consumption has gained great traction in policy circles (see my 24 April Special Economic Study, “China’s Rebalancing Challenge”). If China pulls this feat off, it would do so considerably earlier in its development than Japan, Korea, and other Asian economies. This only underscores China’s amazing capacity to leapfrog everything we know about economic development. Export-led Asia is finally coming to grips with the need to diversify its sources of growth. Given the likely consolidation of US consumer demand -- long the region’s most important customer -- that’s certainly a good thing. A rebalancing of the Asian growth model is a big plus for an unbalanced world. As I put all these pieces together, I now believe that the odds are shifting away from a disruptive global rebalancing. That tempers my long-standing concerns over the possibility of a sharp decline in the US dollar and a major back-up in real long-term US interest rates that such a currency crisis might have triggered. Lest I be accused of succumbing to the ravages of terminal jet leg, I assure you that I am still mindful of the ever-present risks that beset a very fragile world. Oil prices above $70 are especially worrisome for the world’s oil consumers. The income- and saving-short American consumer concerns me most in that regard -- especially as the wealth effects from the US housing bubble now start to fade. The mounting geopolitical risks associated with the “Iran problem” -- all too reminiscent of the build-up before the Iraq War -- only compound my fears that oil-related disruptions of the world economy are here to stay. Nor do I dismiss the politically-induced backlash to globalization that has raised the distinct possibility of an outbreak of protectionism; Washington-led China bashing remains the biggest risk in that regard. And speaking of Washington, the US is rapidly becoming the global poster child for fiscal irresponsibility -- not exactly a constructive development for the world’s biggest borrower. No, I am not prepared to give an unbalanced world the green light. But it’s time to give credit where credit is due: First, to globalization for holding down inflation. Second, to central banks for collectively embarking on policy normalization campaigns. Third, to the stewards of globalization for facing up to the imperatives of architectural reform. And fourth, to Asia -- especially China -- for recognizing the unsustainability of export-led growth models. Notwithstanding the risks noted above -- all of which need to be taken very seriously -- I am delighted that the global economy finally seems to be taking its medicine. Let’s hope the cure works.
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The Yield Curve's Uncertain Message
May 01, 2006
Richard Berner (New York)
The Treasury yield curve re-steepened bearishly over the past two months; 10-year yields jumped by 50 basis points, swinging the 2-year to 10-year curve from 15 bp inverted to +15 bp. That resteepening reflected a pronounced shift in expectations about the outlook for growth and more recently for inflation both at home and abroad. In fact, signs of stronger non-US growth and the Bank of Japan’s decision to end its quantitative easing policy were strong overseas catalysts for the selloff. With much of our story about the US economy in the price, we turned neutral on US bonds three weeks ago (see “Turning Neutral,” Global Economic Forum, April 10, 2006). For investors, we think the message still is that the payoff to being short is small for now, although better buying opportunities may lie ahead. But there is also a key message for monetary policy in the steeper yield curve: It gives the Fed latitude to pause after the May FOMC meeting, and to evaluate whether, as we believe, further tightening is needed. That interpretation may seem odd, because in the past, a bearish steepening has often been a signal that the Fed was falling behind the curve. Sure enough, in the wake of Fed Chairman Bernanke’s congressional testimony last week, some investors think the Fed is now at risk of doing just that: After all, he signaled that “even if in the Committee's judgment the risks to its objectives are not entirely balanced, at some point in the future” there may come a pause in the tightening cycle. In my view, however, the recent steepening doesn’t inherently mean that the Fed is lax about inflation. That’s because at least some of the rise in long-term rates is the product of rising “term premiums” — the compensation investors need to hold, say, a ten-year note instead of rolling over a sequence of short-term deposits to the same maturity. By making financial conditions less accommodative, the rise in term premiums actually reduces the need for the Fed to tighten. With the Federal funds rate in the range that most officials would describe as neither accommodative nor restrictive, the rise in term premiums means that the Fed can afford to pause and evaluate the outlook after moving to a 5% level at the May 10 FOMC meeting. But pausing is not the end of the story: We still think the Fed has a little more work to do, and that the funds rate will peak at 5¼%. The interpretation of the yield curve and term premiums is, of course, not quite that simple. For starters, there is an important interplay between the shape of the yield curve and monetary policy that is critical for assessing both. Fed officials try to parse term premiums as indicators for policy and of financial conditions. To be sure, the level of long-term rates reflects expectations of policy’s future path, distinct from any term premia. But a rise in term premiums that pushes up long-term rates and tightens financial conditions will influence how policymakers view the stance of policy. Conversely, monetary policy has shaped term premiums themselves and thus the yield curve in important ways. Secularly, a credible monetary policy has steadily reduced the volatility of inflation and thus the inflation volatility component of the term premium. And as Ben Bernanke noted in his first speech as Fed Chairman in February, in turn, “price stability both contributes importantly to the economy's growth and employment prospects in the longer term and moderates the variability of output and employment in the short to medium term.” Indeed, he pointed out, “during the past twenty years or so, in the United States and other industrial countries the volatility of both inflation and output have significantly decreased — a phenomenon known to economists as the Great Moderation.” That has reduced the real volatility component of the term premium. But there is also a recent and important cyclical aspect to the relationship: In my view, certainty about the Fed’s policy path during 2004-05 produced a cyclical reduction in term premiums. The Fed then was renormalizing rates at a measured pace to avoid a replay of the sharp and volatile rise in yields that accompanied the 1994 tightening cycle. Conversely, a less-certain future path for monetary policy now seems to be contributing to a rise in term premiums — a rise that has long been part of our case for higher yields (see “The Term-Premium Case for Higher Yields,” Global Economic Forum, January 20, 2006). The path of monetary policy — and policymakers’ guidance associated with it — is less certain than over the past two years as it increasingly depends on the evolution of the medium-term economic and inflation outlook. In particular, market participants face three sources of uncertainty in these relationships — uncertainty that could steepen the yield curve slightly further. The outlook itself seems more uncertain, because several crosscurrents are at work. Pent-up demand for capital spending and hiring, strong income gains, still-favorable financial conditions, and hearty global growth are among the important positives. Supply-driven energy price spikes, rising interest rates, and the incipient decline in housing activity and in the growth of housing wealth are actual or potential negatives. The outcome of the tug of war between those two sets of forces is still undetermined. In addition, the critical relationship between the economy and monetary policy itself seems a bit more uncertain than in the past. I think that the US economy’s sensitivity to changes in interest rates has steadily declined over the past three decades as financial deregulation and innovation have given borrowers greater access to credit than ever before. Borrowers thus can better smooth consumption in the face of cyclical shocks (see Dynan, K., D. Elmendorf, and D. Sichel, 2005, "Can Financial Innovation Help to Explain the Reduced Volatility of Economic Activity?" Journal of Monetary Economics, forthcoming). And borrowers also have much greater flexibility to assume or lay off interest rate and other risks at ever-declining cost by using hybrid ARMS, mortgage refinancing, and auto leases. Moreover, consumer durables and business equipment now depreciate more rapidly than in the past, reducing the interest-rate sensitivity as a component of the user cost of capital. The term premiums themselves are uncertain because even the highly sophisticated models the Fed uses to calculate them are inherently simplifications of reality. And the lags with which monetary policy affects the economy are also changing. I think that they have probably shortened over the past several years as financial innovation has speeded the transmission of information and as securitization has put more financing on a mark-to-market basis. The uncertainty about the effects of these changes, together with the Fed’s risk management approach to setting policy, means that officials can take pause to take stock of what they have accomplished. Finally, the evolution in the way the Fed communicates with market participants and the public involves additional uncertainty. Unlike the past two years, Fed officials now want to comment about monetary policy only insofar as it is contingent on the economic outlook, and without seeming to provide guidance that appears to be a commitment to action. For their part, market participants must wean themselves from the notion that the Fed would telegraph the next policy move as well as the stopping point for monetary tightening. As Chairman Bernanke noted last week, “Of course, a decision to take no action at a particular meeting does not preclude actions at subsequent meetings.” So while market participants interpreted his statements as dovish, we see them as neutral. Like it or not, it depends. Beyond the usual litany of risks I cite about the outlook, the inflation prognosis is now clouded with more uncertainty than before and may thus pose a risk. Core inflation has been subdued, and firmer labor markets have yet to promote a meaningful upturn in wage pressure as measured by the Employment Cost Index (ECI). But longer-term inflation expectations by two measures are drifting higher again: Five-to-ten year inflation expectations in the University of Michigan canvass of consumer sentiment rose to 3.1% in early April, close to a 10-year high. And breakeven inflation between five and ten years has recently risen by 20 bp to 2.65% Such increased inflation expectations coupled with tighter labor markets will eventually fuel wage pressures that complete the circle of inflation. The risk is that they come a bit later than expected, and probably just when market participants think that cyclical inflation risks are a relic of the past..
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Modifying Interest Rate Outlook
May 01, 2006
Takehiro Sato (Tokyo)
Chances of a rate hike coming at the June MPM growing The Outlook Report for economic activity and prices in F2006 and F2007 issued by the BoJ at the end of April represents the rosy scenario. The report begins by stating that “the conditions of persistent oversupply have been dispersed and the output gap seems now to have closed.” It goes on to note that “the outlook deemed most likely by the Bank for economic activity and prices two years into the future” under stable price conditions is for “Japan's economy to continue expanding with balanced domestic and external demand.” As for risks, it goes on, “the risks that are most relevant to conducting monetary policy, looking over a longer time horizon and taking account of the cost incurred when risks materialize, however improbable they might be, … the stimulus from monetary policy to economic activity and prices may be amplified against the backdrop of improving corporate profitability and a turnaround in price developments. In this situation, given that the output gap has closed, there is a risk in the medium to long term of larger economic swings, resulting in large fluctuations in the rate of inflation.” The latter is expressed obliquely, but seems to allude to the risk of an asset bubble. The Bank also noted that even if its outlook for the economy and prices is not fulfilled, the downside risks are diminishing, and thus believes that overall risk is on the upside. This amounts to a declaration that ZIRP (zero interest rate policy) could be abandoned at any time. Naturally, there was no direct reference to the timing of the rate hike, but reading between the lines, it looks as if the Bank may increase the rate any time it chooses. So although our main scenario for the timing is still the monetary policy meeting on July 13-14, we think the possibility of this coming earlier at the June 14-15 MPM has risen. Reasons why we think the possibility of June has grown Our new subjective distribution of probabilities is 30% for June, 60% for July, and 10% for August or later. We have not changed our stance that July 14 is X day, but we think the BoJ is more inclined to move early. Also, June 15 and July 14 are the final days for the reserve accumulation period for each month, so the chances of a rate increase happening then are higher than the meeting dates for August and September. We have three reasons for thinking that chances for June have increased. 1) US to halt interest hikes soon: The summary of the previous FOMC meeting in March suggested strongly that the rate hike cycle would be ending soon. The FOMC’s meeting schedule through the Jul-Sept quarter is May 10, June 28-29, August 8, and September 20. If the FOMC halts its interest rate increases at any of those dates, the BoJ will want to normalize its policy interest rate as quickly as possible to prevent market disorder from the shrinking US-Japan interest rate gaps. 2) BoJ outstanding balance of current accounts to be around ¥10 trillion toward the end of May: The outstanding current account balance held at the BoJ was ¥18.9 trillion at the end of April, falling below ¥20 trillion. The Bank is trying to reduce its balance to around ¥15 trillion at a relatively fast pace, so its behavior so far is just as expected. Judging from the maturity date for fund-supplying operation balances, however, the outstanding balance of current accounts could drop to ¥10 trillion by the end of May. Since past that point there is a risk of the uncollateralized overnight call rate rising, the pace of reduction will have to slow. If the outstanding balance of current accounts starts approaching required reserves, however, the market will likely become jittery as it sees a rate hike coming, and start to push for such a move. 3) Concerns for the bond market: Inflation concerns have strengthened somewhat on high oil and material prices, and Japan is becoming less of an exception amidst destabilizing bond markets worldwide. The JGB market barely withstood the 2% wall, but we can no longer deny the possibility of breaking out above 2%, depending on how the US bond market behaves. So, policy authorities may believe that hiking the policy rate at an early date will be helpful in stabilizing the bond market. What could impede this rate hike scenario is an appreciating yen amid rising expectations for the Fed to cease tightening. However, since the yen is still in a very inexpensive range in real effective terms, a high yen/low dollar situation like the current one is not much of a problem, despite the pace of yen appreciation. Modifying our interest rate outlook Since there is a possibility that ZIRP may be abandoned sooner than we previous expected, we have revised our interest rate table (see full note) to project one policy interest rate hike in 2006 and two in 2007 for a total of 75 bp. We have accordingly slightly raised our long-term interest rate estimate. We think the rate hike will be smaller than what is being priced in by the market now because, as before, we are keeping in mind that 1) we are more conservative in balancing market consensus and BoJ forecasts for price trends, and 2) after F2007, the harmonization of monetary and fiscal policy will be a more important political agenda.
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