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Sent: Friday, November 08, 2002 9:06 AM
Subject: [Stephen Roach : Battle of the Central Banks Global Economic Forum:
Global]
> At least there is one economist that can spell DEFLATION or spit out the
D
> Word D
>
>
> -------- Original Message --------
> From: Stephen Roach <Stephen.Roach@xxxxxxxxxxxxxxxxx>
> Subject: Global Economic Forum: Global
> Resent-From: globalecon@xxxxxx
> To: globalecon <globalecon@xxxxxx>
>
> Battle of the Central Banks
>
> It's hard to figure. The Federal Reserve just eased by 50 bp, slashing
> its overnight lending to 1.25%. The European Central Bank did the
> opposite. It held its policy rate steady at 3.25%, fully 200 bp above
> the Fed's new target. Of course, there's no hard rule that requires
> central banks to follow the same script. But since both institutions
> are inflation targeters, this divergence is puzzling. That's especially
> the case if you believe, as I do, that pricing is increasingly
> determined in the same global marketplace that Euroland and the United
> States have in common. Who's got is right?
>
> My vote is with the Fed. Although the US central bank won't ever come
> completely clean with its motives, there is little doubt, in my view,
> that the FOMC has gone into a deflation-prevent mode. The smoking gun
> can be found in the just-released minutes of the 24 September policy
> meeting, where the Fed made explicit its concerns over the possibility
> of "a nominal inflation rate near zero." This is about as plain as it
> gets in Fedspeak - the perils of deflation are no longer being dismissed
> out of hand. And with good reason. Inflation as measured by the broad
> GDP chain-weighted price index slid to just +0.8% YoY in 3Q02, its
> lowest comparison since 1950. Moreover, the math of aggregate pricing -
> outright deflation in tradable goods (-0.8%) and increasingly intense
> disinflation in services (+1.8%) - suggests that there could well be
> more to come on the road to deflation. Such an outcome, in the
> typically understated words of the FOMC, "...could create problems for the
> implementation of monetary policy." Not wanting to risk such a
> possibility, the Fed is now acting as if it were a given. That follows
> the basic precepts of their own anti-deflation script to a tee (see
> "Preventing Deflation: Lessons From Japan's Experience in the 1990s," by
> Alan Ahearne, et. al., Federal Reserve International Finance Discussion
> Paper #729, June 2002).
>
> With Asia in deflation and America at risk of a similar fate, that means
> fully 54% of the global economy (on a purchasing power parity basis) is
> now in the deflation zone. Europe is hardly deserving of a special
> exemption. While its headline inflation rate is currently slightly
> north of 2%, there's nothing but downside in the not-so-distant future,
> in my view. While our official forecast calls for a 1.7% Euroland
> inflation rate in 2003, I fear that the risks are now pointing toward a
> much lower inflation outcome. Domestic demand growth has been vaporized
> (-0.1% over the past four quarters) and the combination of a weak global
> economy and the lagged effects of a stronger euro are hobbling external
> demand growth. Moreover, Euroland's stabilization policies are now
> "pro-cyclical", with the Stability Pact preventing further fiscal
> stimulus and the ECB stubbornly wedded to targeting inflation in a
> deflationary world. In addition, reforms have fallen victim to the
> political process, especially in Germany and France. And persistent
> market rigidities - both for labor and product markets - inhibit the
> efficient allocation of resources. In an increasingly deflationary
> world, I fear that Euroland is a deflationary accident waiting to
> happen.
>
> Which brings us back to the ECB. Incremental to the end, Europe's
> central bank is treating the current policy debate as
> business-as-usual. Yet with fully 54% of the world in the deflation
> zone, this is anything but business as usual. Yes, in the strict sense
> of its mandated operating procedures, the ECB's reluctance to move is
> understandable - the current inflation rate remains fractionally above
> the upper end of the 0-2% price stability zone. But that approach is
> fraught with great peril in a deflationary world. The ECB would be well
> advised, under the circumstances, to abandon its backward-looking
> approach is favor of setting policy with an eye to forward-looking
> risks. The best the ECB has been willing to offer under these
> circumstances was an easing bias at its 7 November Council meeting -
> setting the stage for what Joachim Fels now hopes will be a 25 bp rate
> cut in early December followed by another such incremental move in early
> 2003. That's not good enough, in my view.
>
> The problem with the ECB's approach is that it is completely out of step
> with the perils of deflation. While we forecasters live and die on the
> basis of our predictions, the policy maker cannot afford to bet on any
> one point estimate of the future. Like investing, policy setting is a
> business of probabilities. The ECB, like any central bank, must frame
> its actions in such a probabilistic context. Here's, again, where the
> Fed anti-deflation script described above comes into play. According to
> this recipe, when the risks of deflation become significant - say in
> excess of 25% - the authorities must then treat such an outcome as their
> central case.
>
> With 54% of the world already in the deflation zone and with Euroland's
> fundamentals flashing a similar warning sign, I would argue that the ECB
> must now embrace the same risks that the Fed has adopted. In this
> climate, it can no longer afford the luxury of betting on the avoidance
> of deflation. That spells aggressive monetary easing - a far cry from
> the incremental approach that remains operative today. The only hope in
> dealing with deflation is to be early with aggressive policy stimulus.
> A backward-looking inflation-targeting approach virtually guarantees the
> ECB will be late and, therefore, ineffective in arresting the problem.
> Incrementalism simply won't work in combating deflation. Just ask
> Japan.
>
> So that's why I am so disappointed in the latest non-action of the ECB.
> By electing to keep monetary policy on hold, the central bank is not
> even paying lip service to the possibility of deflation. Instead, it is
> treating current and prospective risks as if they are an everyday
> occurrence. That's the same denial that got the Bank of Japan into
> trouble and that lulled the Fed into a false sense of complacency. Given
> the sad state of the Euroland economy, the ECB cannot afford to take
> that risk. With the risks of worldwide deflation mounting, it would be
> foolish to operate under the smug presumption that Europe will be spared
> the same fate. This is not the time to fall back on the false comfort
> of ever-imperfect forecasts. This is a time to act decisively on the
> basis of shifting probabilities. The consequences of too much monetary
> stimulus pale in comparison to the costs of deflation.
>
> Stephen Roach (New York)
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