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Monday June 27, 2005 - 21:19:08 GMT
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Not Just A Long-Rate Conundrum

Not Just A Long-Rate Conundrum

Central bankers the world over readily note that long-term rates are inexplicably low for this point in the business and tightening cycles. The conundrum moniker chosen by Greenspan in February is now uttered by every other person from Wall Street to Main Street to best explain what can't be explained.

But monetary policymakers are themselves having an increasingly difficult time explaining why rates need to be higher when inflation is still relatively contained. When monetary aggregates stopped being a guide for interest rates, the inflation rate and nominal GDP for some, filled the void. It now seems that inflation targeting is not giving the appropriate signal for official rates that c banks desire. Maybe Goodhart's Law applies to more than monetary aggregates as anchors to monetary policy (once the aggregate is chosen to guide policy it stops to real economy and price level breaks down.

Oh there is inflation for sure in energy prices, real estate and commodities generally. But the inflation that c bankers fear and associate with more deeply seated threats to price stability are on the wage side of the equation. And while wages are rising they are anything but inflationary. Employment conditions are mixed...tightening in some fields in the US but generally loose in Europe and Japan. Equally growth rates are mixed...higher in more liberalized economies and lower in less liberalized economies. But as the BIS noted today in its 75th Annual report, we are in a world of "lower and less volatile inflation accompanied by higher and less volatile output growth."

What's an uneasy collection of central banks to do? Slay the only inflation dragon a controlled release of the air in the property market bubble...the asset bubble that low rates have arguably created and supported. And check the incentive for investors to hunt for yield with sub-optimal concern for risk (goes for debtors and creditors alike). So what if long-term rates are not aiding in the transmission of tighter monetary policy. Slap investors into consciousness with plenty of rates hikes will do the trick. Greenspan could achieve this in a sentence no doubt.

But the Fed is not playing. Greenspan's Fed will not target asset prices simply because the typical policy anchors (GDP and inflation) are not offering much guidance. Moreover, pricking regional real estate bubbles in the US with a ten penny nail is no way to get the desired results. Too much downside for the Fed to go after frothy property prices with a blunt Fed funds instrument. A sharp correction in the most elevated real estate markets in the US would risk a serious downturn in consumption for the whole economy.

However, the Fed isn't the only entity refusing to dance to what the DJ's at the BIS are spinning. European monetary policy is largely played out. The roadblocks to growth and employment in the Eurozone (as well as pricing power) lie in instituting structural reforms...liberalizing labor markets first and foremost. But doing so means the governments that back such measures might as well ask the opposition to form a government (Germany's best hope at reform is in September when the SPD get voted out and CDU's Angela Merkel is voted in and is a Thatcherite).

Additionally central banks must navigate through potentially dangerous waters. Apart from the real estate bubble bursting, the $60-oil headwind is formidable...more to growth than inflation. So are the risks to the dollar from US external imbalances ($2.25bln a day in foreign savings to finance it). And the dollar and US asset prices generally face rising risks from a possible trade war with China by the fall. And what if the bond market conundrum goes away quickly (maybe a surprise early yuan reval could be the catalyst)?

Sure there is every reason to assume that robust US growth will continue uninterrupted. Nevertheless, from a policy standpoint, the level of confidence in setting monetary policy is in decline as risks of shocks rise. The notion that the Fed can infer in advance another 100-150bps in regular quarter point rate hikes is flawed. The Fed may end up taking the funds rate to 5.00% before pausing, if it successfully navigates around these shocks and the current trend of strong growth persists. On the other hand the Fed may be forced to pause or even reverse monetary policy if a sufficient shock materializes. The point is that the Fed's days of bring able to promising anything on Fed funds are numbered...just as the ECB should not be promising a rate hike or a rate cut. Central bankers generally need to normalize rates, but the fine print that goes with this directive should be...subject to change without advance notice.

David Gilmore


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