The Hindu Business Line : Fear not the Fed

Financial markets do not have to fear the Fed. Mr Alan Greenspan has decided that the process of reversal of the US current account deficit is well under way and that there is no need to do anything drastic. Therefore, he has reduced the likelihood of policy-induced economic slowdown to reduce imports and the current account deficit significantly. Mr Greenspan will not rock the boat, says V. Anantha Nageswaran

ON<150>E OF my former colleagues gently chided me for my characterisation of the policy dilemma of the American Federal Reserve as `Party versus Pain'. That was the title of my last column published on January 31. He felt that it carried moral overtones and that central banking decision-making was about trade-offs in a grey zone. It was a very fair point and certainly it was not my intention to cast the issue in moral tones.

The decision before the Federal Reserve chief, Mr Alan Greenspan, was, and is, whether he had to take proactive measure to restrain the American current account deficit or let market forces determine the outcome. His speech in London on February 4 provided the answer. Financial markets do not have to fear the Fed. He is not going to rock the boat. The concerns of the Fed on `excessive risk-taking', expressed at the December meeting, may be just one-off.

Chairman thinks current account deficit has peaked

Mr Greenspan has decided that the process of reversal of the US current account deficit is well under way and that there is no need to do anything drastic. Therefore, he has reduced the likelihood of policy-induced economic slowdown to reduce imports and the current account deficit significantly.

His hope that the current account deficit would shrink is based on three arguments, broadly:

(i) European exporters have almost exhausted their ability to absorb the strength of the euro in their price margins. So, prices would begin to reflect that and, therefore, it must affect American import prices and import quantities with uncertain final outcomes, of course (depends on elasticities of demand).

(ii) Household savings would begin to rise. His speech, in my view, was not clear on this aspect. He seemed to suggest that the equity withdrawal from home values has pretty much run its course.

(iii) He also expects that the debate on fiscal consolidation and restraint would lead to some concrete outcomes in that direction. The truth is that the jury is still out on that and one has more reasons to be sceptical than hopeful.

However, even if there is a ring of truth to all of these, I wonder if they would suffice. Here is why and I quote from his speech:

Why the Chairman might be too optimistic

(American growth is well ahead of both the Eurozone and Japan and will be so in 2005)

"As is well-documented, the responsiveness of US imports to US income exceeds the responsiveness of US exports to foreign income; this difference leads to a tendency — even if the United States and foreign economies are growing at about the same rate — for the growth of US imports to exceed that of our exports."

Let us examine if the growth rates would be higher in the US than elsewhere in the coming year(s). One, consensus forecasts say so. Two, the Q4 GDP in the US is bound to be revised to as high as 4.0 per cent. There was an error by Stat. Canada and durable goods shipments in December have already been revised higher. That may be history. But, going forward into 2005, short of policy action, there is no reason why growth should be less than 3.5 per cent. After all, the price of oil has retreated and at these levels, it has not threatened economic growth.

Corporations are flush with cash and leaner. Jobs growth is picking up. February should make up for January's weak numbers. Household balance sheets have been re-built, unless housing collapses. Why should it collapse when household incomes are rising and real rates both in the short and in the long-end are so low?

In the Eurozone, I am not sure if the most optimistic forecasts for GDP growth would exceed 2.0 per cent. In Japan, the Small Business Confidence Indicator has been declining since April 2004 and, if any, the Bank of Japan has become less optimistic on growth in recent months than it used to be.

It is very well possible that both these economic zones — Eurozone and Japan — would witness accelerated growth in 2006 and, perhaps, Greenspan hopes that a weaker dollar in 2005 would then set the stage for a significant decline in current account deficit in 2006. It is a matter of judgement if that is the right thing to do. Both of them, I concede, are undertaking decent to significant economic restructuring — some micro and some macro. However, another year of dollar weakness might actually undermine their growth prospects for 2006.

Therefore, I am not entirely convinced that a natural and gradual process of adjustment would see the current account deficit in the US come down or even stabilise at current levels. If I am correct, then the dollar weakness should resume against other major currencies, particularly since the G-7 meeting has not endorsed any specific and time-bound action on Renminbi revaluation.

Financial markets might `run away' with his satisfaction

In addition to all the above macro-economic arguments for some form of pre-emption, I can cite a financial market related argument too.

Based on whatever we know, one is unable to arrive at a cogent and consistent reason for the current low level of real long rates in the US (see chart) and elsewhere. Arguments such as the Asian buying of US Treasuries, policy credibility in the US and that the dollar assets are great stores of value (John Makin, January 2005) do not explain why the 10-year Bunds should be trading at 60-70 basis points below the Treasury 10-year Note Yield and also the low level of credit spreads globally.

Therefore, it is not just about the US long rates. Low interest rates are a global phenomenon. The only argument that makes sense, in my view, of course is the one made by Samuel Brittan in FT this week. It is that global savings far exceed investment opportunities.

If that is the case, then continued 'measured' and gradual tightening of interest rates in the US would prolong the situation of too much savings chasing ever-shrinking opportunities, inflating or creating bubbles in asset prices since there are only limited genuine investment opportunities. Perhaps, Mr Greenspan has reckoned that it is an acceptable risk to live with.

`Carry trades' are not at risk from policy action

(But opportunities could be limited and narrower in any case)

If the Federal Reserve has decided to remain very predictable and be responsive to incoming data rather than be pre-emptive, then it does make the case for continued 'carry-trades' although opportunities have shrunk. They shrunk in 2004 and would be even more limited in 2005.

There will be limited and spasmodic opportunities to make money of long positions. So, the range of financial market outcomes would be `Significant losses - boring - limited gains', given current valuations in most asset markets in most locations.

Of course, that is my personal assessment and therefore, it does point to where the risks lie in my view, from a financial market perspective.

(The author is the Founder-Director of Libran Asset Management (Pte.) Ltd., Singapore. The views are personal. Please address feedback to van@libranfund.com)

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