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ti Global: The Test Stephen Roach (from Hong Kong) The US Federal Reserve is behind the curve and scrambling to catch up. Inflation risks seem to be mounting at precisely the moment when America s current-account deficit is out of control. Higher real interest rate s are the only answer for these twin macro problems. For an unbalanced world that has become a levered play on low real interest rates, the lon g-awaited test could finally be at hand. In an era of fiscal profligacy, real interest rates are the only effectiv e control lever of macro management. It is important to stress the re al dimension of this construct -- the need to strip out the money illus ion associated with fluctuations in the price level and focus on inflati on-adjusted interest rates. From that simple vantage point, Americas c entral bank is swimming upstream. Measured tightening is being largely offset by a measured increase in underlying inflation -- muting the impa cts of the Federal Reserves efforts to turn the monetary screws. And i ts become a real footrace: The Fed tightened by 25 basis points on Marc h 22, only to find that a day later the annualized core Consumer Price I ndex accelerated by 10 bp. In fact, the acceleration of the core CPI fr om its early 2004 low of 11% y-o-y to 24% in February 2005 has offset fully 74% of the 175 bp increase in the nominal federal funds rate that has occurred during the current nine-month tightening campaign. At the same time, Americas current account deficit went from 51% of GDP in ea rly 2004 to a record 63% by the end of the year -- a deterioration that begs for both higher US real interest rates and a further weakening of the dollar. The response on both counts has paled in comparison to what might be expected in a normal current-account adjustment. The answer to that question, of course, hinges on o ne of the slipperiest concepts in economics: the neutral policy rate. This is the magic threshold at which monetary policy is judged to be pe rfect -- neither accommodative nor restrictive insofar as its impact on inflation or the real economy is concerned. The problem with neutrality is that it is only a theoretical notion -- we honestly dont know the a ctual number. In that respect, its just like potential GDP growth or the non-accelerating inflation rate of unemployment (NAIRU) -- equall y brilliant macro constructs that are literally impossible to measure. Such is the sad irony of macro policy management: The key metrics we nee d to steer the economy are not posted in the engine room. In their rare candid moments, the authorities will confess that this is a very touchy -feely process -- youll know neutrality when you get there. That hardl y instills much confidence in the science of macro policy. But I gues s thats why we pay the fiscal and monetary authorities the big bucks. So lets venture an educated guess: Say, for purposes of argument, that t he neutral real federal funds rate is 2%. I didnt pluck that number o ut of thin air: Its approximately equal to the 19% long-term average o f the inflation-adjusted policy rate since 1960. It makes some sense -- albeit far from perfect sense -- to define this metric as the average s hort-term real interest rate that, by definition, would be consistent wi th average outcomes for growth and inflation. But theres now a problem : Neutrality no longer cuts it for a Fed that is behind the curve with r espect to the twin concerns of inflation and current-account financing. Having played it cute and waited too long, the Fed must now aim for a restrictive target in excess of 2%. Then add in some upside to the core CPI of about 275% and, presto, the Fed needs to be shooting for a nominal funds targ et of around 575% -- or more than double the current reading. If the Fed stays with its measure d approach of doling out the tightening in 25 bp installments, then it w ould finally hit that target 18 months from now in September 2006. Unfo rtunately, given the long and variable lags of the impacts of monetary p olicy, the twin genies of inflation and the current-account adjustment m ight be well out of the bottle by then. If that were the case, the 3% t arget on the real funds rate would translate into something higher than 575% in nominal terms. Little wonder that talk is now rampant of stepp ing up the pace of tightening. If you disagree with some of my a ssumptions, plug in your own metrics on neutrality or the future path of the core CPI. But I would venture to guess that the answer in all but the most heroic cases would still produce a nominal target for the polic y rate that is well above the current 275% reading. And that sets the stage for the real test: the sensitivity of the US economy and a US-cent ric global economy to higher real interest rates. From my perspective, this is where the rubber meets the road for the Asse t Economy. Lacking in support from labor income generation, Americas high-consumption economy has turned to asset markets as never before to sustain both spending and saving. And yet asset markets and the wealth creation they foster have long been balanced on the head of the pin of e xtraordinarily low real interest rates. The Fed is the architect of thi s New Economy, and most other central banks -- especially those in Japan and China -- have gone along for the ride. Lacking in domestic demand, Asias externally led economies know full well whats at stake if the a sset-dependent American consumer ever caves. And so they recycle their massive build-up of foreign exchange reserves into dollar-denominated as sets, thereby subsidizing US rates, propping up asset markets, and keepi ng the magic alive for the overextended American consumer. Asset markets around the world are now quivering at just the hint of an u nwinding of this house of cards. And they quiver with the real federal funds rate barely above zero. What happens to these markets and to an asset-dependent US economy should the Fed actually complete its nasty ta sk of taking its policy rate into the restrictive zone? The main reason is that the Fed and its reck less monetary accommodation have fueled multiple carry trades for all to o long. And those trades are now starting to unwind, as spreads widen i n investment-grade corporates, high-yield bonds, and emerging-market deb t (see Joachim Fels March 23 dispatch, The Partys Over). Can an eve r-frothy US housing market be too far behind? The optimists tell me not to worry -- that the real side of the US economy barely skipped a beat in the face of wrenching unwinding of carry trades in 1994. America was much more of a normal economy i n 1994 -- with a personal saving rate of 48%. It had yet to experience the joys of consuming and saving out of assets. The equity bubble of t he late 1990s and the property bubble of the early 2000s -- both outgrow ths of extraordinary monetary accommodation, in my view -- changed every thing. Now it is a very different animal -- the Asset Economy -- that m ust come to grips with monetary tightening. Largely for that reason, I still dont think Americas central bank is up to the task at hand. In the face of disruptive markets or growth disa ppointments, this Fed has repeatedly opted to err on the side of accommo dation. I suspect that deep in its heart, the Federal Reserve knows wha ts at stake for the US -- and for the world -- if the asset-dependent A merican consumer were to throw in the towel. Unfortunately, that takes us to the ultimate trap of global rebalancing -- a realignment of the wo rld that requires both higher US real interest rates and a weaker dollar . Should the Fed fail to deliver on the interest rate front, I believe that the US current-account correction would then be forced increasingly through the dollar. And that would redirect the onus of global rebalan cing away from the American consumer onto the backs of Europe, Japan, an d China. Call it a beggar-thy-neighbor monetary policy defense -- pus hing the burden of adjustment onto someone else. The big mistake, in my view, came when t he Fed condoned the equity bubble in the late 1990s. It has been playin g post-bubble defense ever since, fostering an un...
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