Reply #52: Global: Razor’s Edge (Stephen Roach)

[54anickel]

http://www.morganstanley.com/GEFdata/digests/20040813-f...

An unbalanced global economy is back on the razor’s edge. High oil prices are taking a toll on the US growth dynamic at precisely the point when a Fed tightening cycle has begun -- a risky combination by any standards. At the same time, a shift to policy austerity in China has led to a modest slowing of that overheated economy, with a good deal more to come. That puts a two-engine world -- driven by the American consumer on the demand side and the Chinese producer on the supply side -- in a zone of heightened vulnerability. As I see it, the risks on the downside outweigh those on the upside by a factor of three to one. I would now assign a 40% probability to a recessionary relapse in the global economy in 2005.

The Federal Reserve is in an excruciatingly difficult place. It’s hard to remember a time when the US central bank last tightened in the face of weakening data flow. But tighten it did, with a measured increase of another 25 basis points on August 10. Far be it for me to be overly critical of this action. After all, earlier this year, I publicly urged the Fed to be bold in executing a normalization of monetary policy by taking the federal funds rate from 1% to 3% in one fell swoop (see “An Open Letter to Alan Greenspan” originally published in the March 1 issue of Newsweek International). Alas, circumstances were very different six months ago. Oil prices were $10 lower and the US had an ample growth cushion. From my point of view, it was important for the US central bank to seize that moment and rebuild its depleted arsenal of policy weapons. Such an “opportunistic normalization” also would have served the useful purpose of unwinding carry trades and the multiple asset bubbles they spawn.

That was then. Suddenly, the US economy looks exceedingly vulnerable. An income- and saving-short American consumer, burdened by record debt levels, has been prompt to respond to sharply rising oil prices. Personal consumption expenditures rose at just a 1% annual rate (in real terms) in 2Q03 -- equaling the weakest increase since early 1995. The quick-trigger nature of this response is ample testament, in my view, to the underlying precariousness of consumer fundamentals. While the just-released July retail sales report points to a rebound in the third quarter, further increases in oil prices in the face of anemic job growth should temper any optimism. Moreover, I am starting to get worried about rapid inventory building in the face of this oil shock; in the three months ending June 2004, total stocks of manufacturing and trade establishments have risen at about a 9% average annual rate -- triple the growth rate of business sales over this same period. This borrows a page right out of the script of the summer of 1974, when the first OPEC shock led to an unwanted inventory overhang that blindsided the Fed and set the stage for severe recession in 1974-75. In short, the window has closed quickly on opportunistic normalization -- the growth cushion has all but vanished into thin air.

The Fed, of course, doesn’t see it that way. Its August 10 policy statement contained a very explicit forecast of better times ahead. Despite recent energy-related weakness, the FOMC maintained that “(t)he economy nevertheless appears poised to resume a stronger pace of expansion going forward.” It is very rare for America’s normally reticent monetary authorities to make such an explicit forecast of the future. Just out of curiosity, we combed the archives back to 1994 (when the Fed first began to release such policy statements) and came up with only one earlier instance when the FOMC was equally explicit in articulating a forecast. It was in June 2002, when America’s post-bubble recovery was flagging once again. The Fed’s press release after the June 26 meeting stated very clearly that “(t)he Committee expects the rate of increase of final demand to pick up over coming quarters.” Unfortunately, that was not one of the Fed’s better calls. Final demand growth averaged an anemic 1.3% (annualized) in the second half of 2002, and a year later the federal funds rate had been lowered from 1.75% to 1.0%. Oops.

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