So just in case 'it isn't just the war, stupid', the Fed does seem to be moving ahead vigourously with battle plan 'B'. (I sure hope George Bush finds the time in his crowded agenda to let himself be briefed on this one). Obviously all the talk of war has put everyone in a macho mood. After Krugman's allusions to the 'Baghdad is for boys, the real men want to go to Teheran' doctrine, this week we have the Fed's McTeer say that 'it would be kind of fun to fight deflation'. He must have a pretty boring life if he thinks this is going to be fun! Mind you, after reading that George Bush has nothing better to do with his Saturday afternoons than nibble pretzel on the sofa while watching football nothing really surprises me any more. (Presumeably this is the couch potatoe minus the six-pack, which must make it even more boring).
More to the point is McTeer's 'as long as you're pumping out money at a faster rate than the demand for money is rising you're going to stimulate spending', since its the 'as long as' bit that's important: the Japanese have been finding that the demand for money is quite capable of running neck-and-neck with its rising supply as the store of value component takes over the heavy lifting from the means of exchange one, in a world where the value of everything else is falling against money, and the speed of circulation is slowing down. (Come to think of it: maybe this is the real force of the critique that economic theory is still too dominated by the world of Newtonian mechanics, maybe to many people have never got their heads round the implications of special relativity theory. The salient point here, I think, is that you can run round and round very fast indeed, and still come back to a place where things have barely moved. Still since all the 'real men in Teheran' BS has gone to my head, I have to confess that I find the Wolfram vision of a set of space-time coordinates floating on a platform of information much more sexy).
Getting back to reality: I think the point about the anti-deflation package looking good on paper since it is not yet tested is an important one. My preoccupation is that, like many others things which look good on paper (and of course operation 'air head' immediately comes to mind) the reality may turn out to be more complex. Remember theory is grey, but life is green. Also worthy of comment is the 'good' deflation 'bad' deflation dichotomy. Virtuous deflation does exist: in some sense we can see an example of it now in China. Prices in some sectors fall in such a way as to produce a general economic expansion. History (in the nineteenth century) or contemporary reality (in China) does also tend to indicate that this virtuous deflation has its own attendant convulsions, as those thrown out of work in the backblast of creative destruction know to their cost. In a sense the 90's was a period of positive sectorial deflation in the US. A dramatic fall in prices in a number of sectors produced a historic expansion 'lifting all boats'. But if the fall in prices, due to the relevant cross-elasticities, fails to provoke real revenue growth in the affected sectors (think post March 2000) then the result can be slowdown and growing output gap.
So then you have to look at what's happening in the rest of the economy. This is what determines in the final analysis if 'good' deflation turns bad. Now conjuncturally we face two other negative headwinds. Firstly China. Of course, in other times, China would be producing the kind of 'healthy' deflationary tonic we all hope for. Falling prices in manufactured products stimulating a general market expansion, and growth all round. But this is not what is happening. China - entering sixth place - is giving the global economy what little push it has, but that is not sufficient to achieve lift-off. It is being more than compensated for by what appears more and more like an irreversible, 'historic', decline in the number two and number three slots: Japan and Germany. So we have what Stephen Roach (see my post yesterday) comes near to calling (and I will call) a negative feedback dynamic. As pricing pressure in the slows down the activity of the large global corporations in the developed economies, this ironically only increases the pressure to outsource in China. Ergo: not only may China be insulated from the growing global slowdown (SARS is another question), it may actually be a positive beneficiary of it.
Secondly, there is the demography. If Japan and Germany are moving backwards, there must be a reason. Simplistic calls for structural reform entirely miss the point. The reason is negative demographics. This argument is explained in interminable detail here>, and here and here. Since this phenomenon, in greater or lesser measure, is about to hit all the developed economies, then the plight of these two may give us some measure of what is to come. All in all then, whilst I think the deflation preparations of the Fed are admirable (in the sense that they are at least trying to do something, and doubly admirable in the light of the complete absence of preparations here in Europe), I think we still have a long way to go before we really start to get the measure of this one.
Most Federal Reserve officials think the U.S. economy will revive once war doubts lift but with corporate pricing power hamstrung, they are still bracing to avert a threat they hope never arises -- deflation.While Fed policymakers have expressed confidence the United States won't suffer Japanese-style deflation, in which falling consumer prices drag the economy lower, part of that faith reflects a willingness to act aggressively if needed."We don't want to get into a position where we get extra headwinds in an environment where we're fighting some other headwinds and that underscores the importance of being ... aggressive and willing to act preemptively." explained Vincent Reinhart, a top adviser to Fed Chairman Alan Greenspan.
The U.S. economy hit a brick wall of war worries and bad weather in February, fueling concerns among some analysts that the stop-and-go recovery was in danger of stopping altogether. Early readings on March appear little better. For its part, the Fed has blamed much of the weakness on disquiet about the U.S.-led war against Iraq and its potential economic impact, saying growth was poised to pick up once war-related worries ease. Officials at the central bank are hopeful that the 12 U.S. interest rate cuts since early 2001 will be ample to stimulate faster expansion. But markets are not so sure. "The Fed thinks they're done but the economic news is not really cooperating," said Bill Dudley, chief economist at Goldman Sachs. "The most likely thing is the Fed's on hold for the time being and we wait to see how the data, the war and the markets behave," he added.
While rising oil costs have pushed overall inflation up the past year, so-called core inflation, which strips out food and energy costs, has been slowing -- the Fed's favorite measure was up only 1.4 percent in the 12 months through February. With core inflation low and the economy weak, some analysts see a risk the United States could end up like Japan, which has been in and out of recession since equity and real estate bubbles popped more than a decade ago. With the benchmark overnight lending rate now at a 41-year low of 1.25 percent, the Fed has had to face the unsettling prospect that short-term interest rates alone might prove an insufficient tool if the economy weakened sharply.Many analysts believe the central bank would be loath to cut rates to zero because that could cause problems in money markets, which count on a positive rate of return to function."That's an issue that's getting a lot of attention these days and we'd have to make that kind of judgment in the context of everything that might be happening," Richmond Fed President Alfred Broaddus told reporters this week, while stressing he did not see deflation as a near-term threat.
Like Broaddus, Reinhart made clear the Fed was conducting due diligence for a prospect he called "quite remote." "You've seen the chairman testify (before Congress). A van pulls up and empties out with staff and they're all carrying briefing books. In an institution like that, what do you think we're doing?" Reinhart quipped when asked if the Fed had been giving more thought lately to how it might battle deflation. Speaking at an economic conference last week, Reinhart laid out a number of tools other than short-term rates that could be used to fight deflation, from pumping money into the banking system to lowering long-term rates by buying U.S. Treasuries. Officials express confidence such measures, while unusual, would prove effective, even while they admit a lack of experience makes it hard to gauge the likely impact. "As long as you're pumping out money at a faster rate then demand for money is rising you're going to stimulate spending," Dallas Fed President Robert McTeer said in mid-February. "I think it would be kind of fun to fight deflation, actually."
Officials in Washington repeatedly stress that the United States is not like Japan, where banking system woes have complicated efforts to spur growth. In Japan, falling prices have raised the burden of debt, adding to bad loans at banks and thus hampering new lending, which weighs on the economy and fuels more price declines. Fed researchers say that if a deflation threat arose in the United States, the key to avoiding a Japan-type spiral would be to act quickly while the now-healthy banking system could still transmit the benefits of an easier monetary policy.Even if prices were to fall, all deflation is not created equal. In December, one Fed official said deflation might not be so dire if it occurred when productivity -- or worker output per hour -- were rising rapidly, as it currently is in the United States. Since rising productivity cuts the cost of output, profits would be buffered even with falling prices.
Steven Kamin, a researcher at the Fed's Washington-based Board of Governors, said last week there was some merit to distinguishing between productivity-related "good deflation" and "bad deflation" caused by a collapse in demand. Still, he warned the economy could easily tip from good deflation to bad if hit by a negative shock. "The good part of good deflation is the productivity growth, it's not the deflation itself," Kamin said.
Source: Reuters News
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