Replies to post #84470 on Zeev's Turnips Patch-No Politics (ZEEV)

[basserdan]

*** Stephen Roach ***

The Failure of Central Banking
Stephen Roach (New York)


The European Central Bank has blown it again -- easing by as little as possible in the face of an increasingly treacherous economic climate. Yet this action should not be viewed in isolation. It is emblematic of a deeper problem that has afflicted central banks over the past dozen years: While the monetary authorities experienced great success in taming inflation, their record in tempering the perils of deflation borders on abject failure. The Bank of Japan has led the way. The risk is that the Federal Reserve and the ECB are now following in its footsteps.

Incrementalism doesn't work in combating deflation. That was one of the key lessons that the research staff of the Federal Reserve drew in a widely noted paper published last year (see Alan Ahearne, et. al., "Preventing Deflation: Lessons From Japan's Experience in the 1990s," Federal Reserve Board International Finance Discussion Paper No. 729, June 2002). Yet that's precisely the approach now being followed by the ECB. The 25 bp easing of 6 March is but the latest case in point -- it is only the sixth easing in two years, bringing the cumulative reduction in the Euroland policy rate to 225 bp since May 2001. Yet the European economy is now in very serious economic trouble. With fiscal policy effectively hamstrung by the Growth and Stability Pact, Europe needs all the greater flexibility from monetary policy. Lacking in domestic demand and largely dependent on external demand, a rising foreign exchange value of the euro makes aggressive monetary accommodation all the more imperative. Unfortunately, that has not been the case.

But there's an added wrinkle to Europe's conundrum. Germany, its largest economy, is probably already in recession. Unfortunately, Germany has entered this recession with only a 1% inflation rate, implying that it wouldn't take much of a contraction to tip fully one-third of the Euroland economy into deflation. Yet there doesn't seem to be much leeway in the rigid EMU policy framework to give Germany special treatment. That's precisely the problem. For a nation whose current structural dilemma goes back to the uneconomic terms of German reunification in 1990 -- a one-for-one exchange rate between the high-productivity West and the low-productivity East -- some policy flexibility is essential. Yet focused on backward looking gauges of pan-European inflation that were still flashing an estimated 2.3% y-o-y increase in February 2003, the ECB's latest incremental move suggests that it remains wedded to its formulistic approach of targeting price stability in the 0 to 2% zone.

Therein could lie Europe's biggest pitfall. From the start, the European Monetary Union has been framed around the "one size fits all" credo. In other words, what's good for Europe is presumed to be good for Germany. This approach may work fine under most circumstances. But when deflationary pressures emerge in the largest economy in the region, all bets could be off. At such extremes, Germany's dominant share in the Euroland economy may well require precisely the special treatment that the ECB refuses to offer. To do otherwise may well risk a contagion of German deflation quickly to the rest of the region. Consequently, in an effort to set policies for the region as a whole, the ECB may be neglecting not only the biggest link in the chain, but also the weakest. To be sure, the outcome is hardly known with precision. But the risks of a German-led deflation in Europe are now rising. In my view, incrementalism under those circumstances may well be a recipe for disaster.

But this is not just the tale of an ECB policy blunder. The world's other two major central banks are equally guilty. Not only did the Bank of Japan set the stage for Japan's wrenching post-bubble workout by tightening monetary policy after Japan's bubble popped in late 1989, but it also failed to ease aggressively once the full extent of the ensuing shakeout became evident. Nor was America's Federal Reserve an innocent bystander to the asset bubble of the late 1990s. By championing the miracles of the New Economy, Chairman Greenspan sent a powerful message to investors that the Fed not only believed in keeping its hands off a rapidly growing US economy but that it also felt that equities were fairly valued relative to the perceived secular improvement in underlying economic fundamentals. While the Fed has since eased in 12 installments of some 525 bp over the past two years, most of that rate reduction came in 2001. Indeed, as the case for deflation has actually gained credibility during the past years, the US central bank has slipped into an increasingly incremental policy mode -- cutting the federal funds rate only one time in 2002 by 50 bp.

There could well be a deeper meaning to all this. I have long suspected that central banks are guilty of having fought the "last war" -- namely, inflation -- for all too long. As the monetary authorities succeeded in squeezing inflation down to extremely low levels, market interest rates were quick to follow. That produced valuation support for equities that was then reinforced by the perceived interplay of a major technological breakthrough (i.e., the Internet) and the productivity-led saga of a New Economy. In other words, under certain circumstances, inflation targeting can spawn asset bubbles. As inflation all but vanished from the scene, the stars were in perfect alignment for just such an outcome in the late 1990s. The failure of central banks was to stick with an old target for too long and not recognize the need to shift their focus to a new target. By fixating on the narrow construct of CPI-based inflation, the authorities overlooked the perils of deflation that arose from a broader inflation of asset markets. My guess is that history will not treat that oversight kindly. Should the world continue to slide down the slippery slope of deflation, a reworking of central bank mandates could well be in order in the not so distant future.

I must confess that this thought always pops into my head when I visit Singapore. And I was there again last week. Several years ago, I had the opportunity to see first hand the battlefield remnants of the fall of Singapore to the Japanese in early 1942 -- billed as Churchill's most devastating military defeat. The image that forever haunts me is that of the heavy artillery fixed in massive concrete bunkers pointed in precisely the wrong direction -- aimed at the sea, where Lt General A. E. Percival was convinced the attack would come from. The Japanese, instead, came from the north -- through the swampy Malay peninsula, and the seemingly impervious citadel of Singapore fell in a matter of days. A 1968 book by Noel Barber provides the best account of this military blunder of monumental proportions. Its title -- <I style="mso-bidi-font-style: normal">Sinister Twilight -- speaks all too well of a similar strategic blunder made by the champions of an earlier era, the world's major central banks. Like Percival, they too may well be guilty of having fought the old war for all too long.

http://www.morganstanley.com/GEFdata/digests/20030307-fri.html

TGIF,
Dan

[Babylon]

Mlsoft, no disagreement from me with your post at all. The reason I am asking, is because I'd like his (or yours, and anyone who'd like to chime in) viewpoint of the impact on the market. The last I remember is he wasn't fond (to put it mildly) of the last rate cut and darn near sowed (I think that's how its spelled, maybe its sewed, anyway...) his bear suit into his skin, once we found out about the 1/2 point rate cut. Just wondering if this were to happen, if he'd walk on all 4's and eat berries. <gg>