Perspective Unlimited

Friday, November 09, 2007

Inflationary or Disinflationary?

Rising oil prices, falling US dollar, skyrocketing commodity prices all point to more inflation for the US economy, or do they? What about the effects of a slowing economy and falling house prices? Just a couple of years ago, the world was toasting to the Goldilocks US economy, growing without inflation, not too hot and not too cold. Now, it is a case of one foot hot and one foot cold, a real dilemma for central bankers.

Asymmetric Monetary Responses

The story went like this. The benign global economy transformed by the supply side revolution of China and other developing economies had brought great benefits in terms of output expansion. Interest rate stayed as low and for as long as they had been for a long time. Even though general consumer price inflation was low, asset prices like housing started to bubble over worldwide. The Greenspan doctrine was that it was too dangerous for central bankers to try to target asset prices, so they were left completely unchecked as the rest of the economy coasted along.

Suddenly there was the realisation that asset prices could no longer be sustained, and the bust came at a time when the world was beginning to face a supply side shortage. Commodity and consumer inflation started to rise, but assets began to deflate. It is easy to treat a patient with fever, give the medicine to bring the temperature down. It is equally easy to treat a patient with hypothermia, just warm him up. But what do you do to a patient with fever and hypothermia at different parts of the body at the same time? This is exactly Tinbergen's dilemma, how do you hit two targets with one arrow? You pray!

Cutting interest rates to support asset prices would risk sending inflation even higher. Not cutting would risk making the post-bubble financial turmoil worse. By December, we will know if Fed is indeed serious about the inflation fighting or is it really an emperor with no clothes. My personal assessment is that Fed will have to make more cuts, even if it strenuously denies it at the moment.

It is also here that the Greenspan doctrine ties itself to intellectual knots. To leave asset price rises unchecked, while opening the door for interest rate cuts and bailouts when asset prices fall is exactly the kind of policy asymmetry that leads the market into making one-sided bets. Revisionist talk this is not, many economists have long been arguing that monetary policies were too loose too long.

Risks for Rest of the World

As difficult a job as the one Bernanke is doing, we have to remember this. When Fed weighs in on its monetary policy stance, it cares only of the risks facing the US economy. Given how dependent the rest of the world is on the US, this is an extraordinary situation. By cutting interest rates and driving US dollar ever lower, it places severe strains on economies elsewhere. Those countries pegged to US dollar will face either higher inflation, or will have to abandon the peg altogether, both of which will lead to more financial turmoil.

The Euro and Pound are both soaring relative to the US dollar at a time their own economies are too entering the down cycle. Just yesterday, French President Sarkozy fired off a warning shot that US could not expect to devalue its way out of trouble of its own making, and implicitly threatened competitive devaluation. While he in reality did not have control over the ECB, he very much captured the mood over in Europe. The sense was that the European economies were at the short end of it all, being punished for someone elses' sins.

What we have seen in the past three months is probably only the beginning act of a period of economic turbulence.


  • I generally agree with what you say. Just a few years ago, Greenspan was so terrified that the US economy was about to enter a deflationary spiral, he cut interest rates to avoid it.

    Until the subprime mess Bernanke was raising rates "all the way" in fact many central banks could see inflation coming were pushing rates up. In Aug 2007 all hell broke loose putting an end to rate hikes.

    Bernanke was in the hot seat on Thursday facing the congressional committee. One congressman couldn't contain his ire and demanded an end to a weak dollar that was "wiping off the value of savings of pensioners". You can see the strain on Bernanke's face. The same congressman also said that core-CPI(which excludes energy + food) is not measuring inflation.

    Next week we will get CPI figures again. I believe the core-CPI is not high. If you look at prices increases in Singapore, most of it is concentrated in food & energy. You don't see the price of your shirt & shoes rising. The Fed policy is based on the core-CPI because it differentiates between inflation (core)that can be fought with rate hikes. The Fed will keep cutting (if it can) until we see the effects of subprime diminishing.

    The US Fed has always counted on Asian govts to shore up the US$. At 1USD to 111 yen, the Japanese exporters are feeling the some point the BOJ will intervene maybe next week. The falling US$ is not a big issue if it is gradual, but the recent attack on the US$ cause markets to panic - this is the 3 or 4th attack in the past 2 years when the DOW fell sharply due to US$.

    The Chinese economic planners would actually be quite happy with a US slowdown because they can't cool their overheated economy on their own. This weekend there was some speculation of rates hike or increased bank reserves ratio again but nothing happened. The Shanghai bourse has fallen by 13%(?) from the peak and appeared to have cooled off.

    The US market will continue to be weak. Emerging markets will be interesting once we see some stability in the US. Russia continues to boom due to oil, India & China have alot of room to grow although stocks look overvalued. Hong Kong would be the most interesting with its US$ peg, proximity to China, rising liquidity. The HKMA swear they will not unpeg, this will give speculators alot of upside to play with.

    The US bourse is now close to the low in mid-Aug. Yet, markets in Asia are holding up. The rise in all asian currencies against the US$ means the Yen-carry trade is not disrupted. Liquidity is going to markets with higher returns. Take the german DAX is still near its high of the year (up 20%) because Russian money flowing into germany has resulted in a boom there.

    After this round of panic(mayhem?), I believe the DOW will drift lower while the emerging markets will perform based on the growth rates of their economy. The US market is now less critical to global growth than 2 decades ago. The US hardly grew this year and Singapore chalked up 7% and China double digits. Even if the US goes into a mild recession, I believe we will be adversely affected our economy will be able to hold up because of China, India and the regional boom.

    By Blogger LuckySingaporean, at 1:13 am  

  • This comment has been removed by the author.

    By Blogger Bart JP, at 10:30 am  

  • Stripping out volatility to get core is in principle fine, so long as oil, food and commodity prices are volatile around an average. But even if oil comes down from current high, it is still an uptrend over the past few years. Real inflation at consumer level is much higher, and the purchasing power of dollar eroded.

    High oil prices also create geopolitical uncertainties. It shifts wealth and financial muscle precisely to the countries that might cause trouble for US and western democracies. Chavez, for one, is using high oil prices to fund a Latin American revolution. Russia is also playing hardball. Of course, there is Middle East. It is not just an economic risk, there is a real geopolitical risk. Which is why there might be more sudden, and dramatic shocks to the markets.

    By Blogger Bart JP, at 10:31 am  

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