Reflation by the Fed is the economic cure
It looks bad, it is bad, and it will probably get worse. But don't presume Armageddon is coming
Thursday 03 September 1998
Russia's financial and economic meltdown can now be seen as the last brick taken out of the wall. Russia, per se, is not of significance in any world economic model but it has monumental political significance. It has acted as a catalyst, forcing international investors and banks to recognise and understand the danger of deflation that is at the heart of this global crisis.
In this last week, global credit and liquidity conditions have tightened considerably as interest rates in credit and sovereign markets have surged. What we are now seeing is the ugly spectacle of systemic financial dislocation. US and European stock markets, which have been in denial for much of the past year, have now started to capitulate. It looks bad, it is and it will probably get worse but we do not have to presume that Armageddon is just around the corner. The time is ripe for the US Federal Reserve to rise to the occasion as custodian of the world's reserve currency and kick-start global reflation. The economic research team at Warburg Dillon Read dared such a prediction in January this year, but we had no real sense then how rapidly the world economy would deteriorate.
Until this week, I was not optimistic that the Federal Open Market Committee (FOMC) as a whole was any closer to this point of view than the Bank of England's Monetary Policy Committee (with one or two exceptions). But I believe that change is now waiting in the wings.
There has been a central bank and market view that as soon as Asia stabilises, inflation pressures will emerge and the Fed and other central banks will have to tighten monetary policy. But this contains a structural contradiction. Asia and Japan, other emerging nations, commodity and stock prices and manufacturing industry won't stabilise until the Fed eases monetary policy. This summer we are seeing a number of rearguard policy initiatives, notably from the Japanese and Hong Kong authorities, designed to fight the fundamentals that are leading to a potential Armageddon scenario. However, the economic and financial asteroid hurtling towards us is still on course, and the only financial Bruce Willis on call resides in the Federal Reserve building in Washington DC.
Despite a stable yen recently and the attempts of the Honk Kong Monetary Authority to support the Hang Seng index, the long end of the US Treasury bond market continues to reach for ever-lower yields, and UK gilts and European bonds are on fire. On the other side of the risk spectrum, stock prices are now tumbling. The emerging market bond yield spread over US bonds, at nearly 1,600 basis points, is more than twice as big as it was at the height of the Asian crisis last October and November.
With Russia knocked out, the focus has switched to Latin America, notably Venezuela and Brazil. But there are still perfectly good reasons to worry about policy failures in Japan as regards financial industry reforms and the reflation of aggregate demand. There are also good reasons to worry about policy failures in China and Hong Kong despite official pronouncements and actions of late. Last but not least, we should watch the knock-on effects of the Asian and emerging markets crisis for banks, particularly - but not only - in Europe.
This doesn't have to involve anything more critical than a pulling in of horns. One of the catalysts for the 1930s depression, after all, was an abrupt withdrawal of international lending and the slump in world exports - and we have early signals that both may now be occurring.
But the biggest barrier to global reflation is the myopia of central banks - also reminiscent of a 1930s failing. The Federal Reserve, in particular, is anxious about the inflation potential of tight labour markets and consumer strength. There are at least three reasons why this view is mistaken.
First, there is no underlying inflation pressure in a world economy characterised by over-production. To understand this, we must look at a range of inflation indicators, not just selected parts of the consumer or retail price index. Second, the negative impact of the Asian crisis on producers and manufacturers in the West has been offset by the positive effect on households - low inflation, record low bond yields. But this precarious balance is not sustainable. As prices, profits, earnings and growth are downgraded, output and capital investment will be curtailed. Employment growth will slow and eventually unemployment will rise.
Third, the stock market has until now been the last defence between the Goldilocks and Armageddon scenarios. No longer. The downturn in equity prices will generate a significant change in the savings ratio in the US and this will feed directly into lower consumption activity. You don't have to be a John Maynard Keynes to figure this out or what it means on a global scale. Regrettably, the UK is in pole position here - and we have just this week downgraded our forecast of growth in 1999 to 0.3 per cent, close enough to recession as makes little difference.
I expect world growth to be around 1.5 to 1.75 per cent this year and to struggle to reach 2.25 per cent in 1999 on several "fingers-crossed" assumptions. Even then, global growth aggregates don't really tell half the story of what is going on and will be likely to ensue in the one-third of the world that is already in recession - in the many emerging nations where poverty, bankruptcy and unrest are reality rather than risk, or in the industrial countries where the cold winds from the Orient and Russia are likely to be picking up this autumn and winter. The prospect of a global recession over the next 12 to 18 months is no longer an outlier on the "tail of the probability distribution curve", as we say delicately in the financial industry.
To confront all these challenges, I fully expect the US to kick off a new economic phase, characterised by monetary reflation - 1 percentage point off short-term interest rates over the next six months, but subject to review because we really don't know how far the Fed will need to go. Base rates in the UK will tumble over the next 12 months. Even the European Central Bank will be hard pushed to justify even the smallest of rate rises, if at all.
The Fed's policy shift, in time, should help to bolster hard pressed and indebted emerging countries and allow them to cut interest rates. It should strengthen commodity prices. And, it is hoped, this should come in time to moderate the economic slowdown in industrial countries where manufacturing is already showing the way.
But all this is speculation: we don't know how many spoonfuls of the medicine are needed, but we need to start to taking it - soon. Until this happens, markets are likely to continue to flirt with Armageddon. We must hope that the Fed and other major central banks are, or soon will be, singing from the same hymn sheet of economic analysis, otherwise we shall all be singing "Armageddon out of here" - or, to pinch a couplet from Bob Dylan's song "Senor":
Senor, senor, do you know where we're headin'
Lincoln County Road or Armageddon?
George Magnus is the Chief Economist of Warburg Dillon Read
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