Friday, June 09, 2006

"Tough Love" by Stephen Roach!

After years of excess accommodation, the US central bank may be trying to reclaim the "tough-guy" image that a credible monetary authority needs.

It’s been a long time since I said something positive about the Fed. That saddens me. The Board -- as insiders call the Washington-based Board of Governors of the Federal Reserve System -- was my first place of gainful employment after grad school. I spent seven wonderful years there in the 1970s, and there will always be a soft spot in my heart for this great institution. It has pained me no end to write of a Fed that lost its way in the bubble-infested waters of the past seven years. But now, for the first time in a long time, America seems about to get a meaningful dose of monetary discipline. Ironically, it could be tougher on the markets than on the economy. For investors, that’s a painful wake-up call, to be sure. But in the end, it’s absolutely essential in order to put an unbalanced, asset-dependent US economy on a sounder and more sustainable course. Three cheers for Ben Bernanke!

Of course, he hasn’t really done anything just yet. The Fed could disappoint -- and end up being all bluster and no action. Or there is always a chance it’s too late -- that America’s imbalances are so advanced, the only way out is the dreaded hard landing. But in my new role as the optimistic pessimist, I am willing to give Bernanke & Co. the benefit of the doubt. By talking tough in the context of only a fractional overshoot of inflation -- an overshoot that may be more statistical than real -- the Fed is sending an unmistakably clear message of a move to policy restraint. And by delivering that message in the context of down markets, the rhetoric of monetary discipline has an even stronger ring. If there’s ever been a time for America’s central bank to take on the markets, this must surely be it. Former Fed Chairman William McChesney Martin put it best in his legendary quip: "The job of the Federal Reserve is to take away the punchbowl just when the party is getting good." For years, the Fed has provided more than its share of refreshments at the biggest party of them all. Those days could now be drawing to an end.

A few weeks ago, I wrote of a crisis of confidence in central banking -- arguing that a profusion of asset bubbles was an increasingly perilous consequence of a successful journey on the road to price stability (see my 22 May dispatch, "Wake-Up Call for Central Banking"). My point was that at low levels of inflation, the policy rule of the inflation-targeting central bank results in exceedingly lower nominal interest rates -- the sustenance of an ever-expanding liquidity cycle. I argued that the monetary authority actually needs to broaden out its targets as it approaches price stability -- paying special attention to excesses building in asset markets. In effect, monetary policy needs to be conducted with an asymmetrical bias in those circumstances -- predisposed more toward tightening than accommodation. This has important tactical implications for the Fed: A tight-money bias at low inflation rates may well be essential if the US central bank is to succeed in satisfying its "dual mandate" of price stability and sustainable economic growth.

My reading of Ben Bernanke’s now-infamous 5 June statement is that he gets it. His hand-wringing over inflation actually seems exaggerated in the context of the downshift he is now expecting for US economic growth. In fact, his statement goes out of its way to speak of a transition to slower growth arising from the combination of higher energy prices and a cooling of the housing market. At the same time, his concern over inflation also seems at odds with some obvious statistical quirks in the aggregate price data. Yes, the core CPI is running at a 2.3% y-o-y rate through May -- in Bernanke’s telling words, "…at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth." The overshoot, however, is due entirely to the notorious "owner’s equivalent rent" of primary residences; excluding this key item -- fully 30% of the core CPI -- the core would have been 2.0% y-o-y in April ( and actually 1.9% excluding the entire shelter category). It is arguable whether the inflation alarm would even have been rung were it not for that statistical acceleration in one of the CPI’s most controversial components. And then, of course, there’s the financial market climate to consider -- an already-meaningful correction in global equity markets and a particularly sharp downdraft in risky assets such as emerging markets and commodities. In a still low-inflation climate, a risk-averse Fed might have been tempted to wait until the dust settles in the markets before flexing its policy muscle.

Bernanke’s conclusion that there has been an "unwelcome" deterioration of inflation -- and inflationary expectations -- can also be challenged on other grounds. The fractional rise in the hourly wage rate in May (+0.1%) throws cold water on the notion that tight labor markets are bidding up the price of labor. At the same time, the sharp recent correction in commodity prices challenges the belief that surging global growth is leading to a coincident boom in input prices that could further exacerbate incipient inflationary pressures. And on a structural basis, the ongoing pressures of globalization continue to act as powerful headwinds restraining any cyclical pressures building on the inflation front. Finally, there’s a tactical policy issue to ponder: At low inflation rates, the strict inflation-targeting central bank has the leeway to make a minor policy mistake; it can, in effect, afford to be late and come in after the fact with a monetary tightening -- suffering the consequences of what should be only a brief detour on the road to price stability. In short, there are plenty of reasons why Bernanke might have elected to wait out this so-called inflation scare. But he didn’t. In fact, he struck early in the game, and this message has been reinforced by a coordinated rhetorical assault by other members of the Fed’s policy-making body.
Maybe I’m reading too much into this, but I think there is an important implication of the Fed’s hair-trigger response to an arguable inflation scare: After years of excess accommodation, the US central bank may be trying to reclaim the "tough-guy" image that a credible monetary authority needs. And there is good reason to believe this sentiment is global in scope. Recent monetary tightenings by the ECB and by central banks in India, Korea, Turkey, South Africa, and even Iceland all speak to a similar disciplined mindset. And these actions all have comparable implications for the global liquidity cycle and world financial markets -- reducing the flow of high-octane fuel that has fed the multiple asset bubble syndrome of the past seven years. I am not saying that central banks are united in their views in targeting asset markets. But I do believe that a strict adherence to inflation targeting may have become a foil that now enables the authorities to turn their attention to other important issues -- namely, the increasingly dangerous excesses of a very powerful liquidity cycle.

This sudden outbreak of monetary discipline around the world very much fits the script of my newfound optimism on global rebalancing. The world’s biggest imbalance -- America’s current account deficit -- is a direct outgrowth of a property-bubble-induced shortfall of income-based saving. Lacking in domestic saving, the US must import surplus saving from abroad in order to grow -- and run massive current account and trade deficits in order to attract foreign capital. To the extent central banks have promoted asset-bubble-related global imbalances by overly accommodative monetary policies, an emerging bias toward monetary discipline is a very encouraging development on the road to global rebalancing. While it’s "tough love" for bruised investors, this may well end up being the requisite correction that clears the decks for the next upleg in the markets. Thank you, again, Ben Bernanke.


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