ROUBINI ON STAGFLATION OUTCOME

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Helicopter Ben goes ZIRP, QE and More…While the Global Economy Enters Stag-Deflation

Dec 17, 2008
The Fed decision yesterday to cut the Fed Funds range to 0-0.25% formalized the fact that, over the last month, the Fed had already moved to a ZIRP (zero-interest-rate-policy) - as the effective Fed Funds rate was already close to zero -and started a policy of QE (quantitative easing) as its balance sheet has surged over the last few months from $800 billion to over $2 trillion. And – as discussed below – the Fed is now undertaking even more unorthodox policy actions.These Fed policy actions are occurring while the US and the global economy is now risking a protracted bout of stag-deflation, a disease that I first discussed as early as January 2008 when I warned about the risk of a global deflation and stag-deflation. While it is now fashionable to talk about such deflationary risks – and the latest U.S. CPI figures confirm that we are entering into deflation – some of us were worrying about the coming deflation well before the mainstream – concerned with short-run and unsustainable increases in commodity prices – discovered the deflationary risks in the global economy.It was clear to those of us that saw early on the risks of a severe US and global recession that, once that recession would emerge, deflationary rather than inflationary pressures would emerge as slack in goods markets, slack in labor markets and slack in commodity markets would emerge. So now we need to worry about stag-deflation, deflation, liquidity traps and debt deflation. Welcome to the world of stag-deflation or, as Krugman would put it, to the world of “depression economics”.So what is the outlook for the US and the global economy in 2009? And what is the likely policy response to the risks of a global stag-deflation? Let us discuss next these two questions…The outlook for the U.S. and the global economy is now very bleak and getting worse as the global economy is experiencing its worst recession in decades. In the US, recession started last December, and will last at least 24 months until next December — the longest and deepest US recession since World War II, with the cumulative fall in GDP possibly exceeding 5 percent. In comparison the last two recessions in 1990-91 and 2001 lasted only 8 months each and in 2001 (1990-91) the cumulative fall in GDP was only 0.4% (1.3%). There is also a risk that this deep and protracted U-shaped recession (the mainstream consensus view of a V-shaped short and shallow recession is now out of the window) may morph into a more severe Japanese style L-shaped recession unless aggressive fiscal policy and recapitalization of the financial system is enacted.The recession in other advanced economies (the euro zone, the UK, other European economies, Canada, Japan, Australia and New Zealand) started in the second quarter of this year, before the financial turmoil in September and October further aggravated the global credit crunch. This contraction has become even more severe since then. I don’t expect growth in the advanced economies to recover before the end of 2009.There is now also the beginning of a hard landing in emerging markets as the recession in advanced economies, falling commodity prices and capital flight take their toll on growth. Indeed, the world should expect a recession (growth in the -1 to-2% range) in Russia and a near recession (growth close to zero) in Brazil next year, owing to low commodity prices. There will also be a very sharp slowdown in China and India that will be the equivalent of a hard landing (growth well below potential) for these countries. In China the latest figures for electricity use, export and imports suggest that the economy is already close to the hard landing scenario of a growth rate of 5%. The deceleration of growth in China is much more rapid than expected.Other emerging markets in Asia, Africa, Latin America and Europe will not fare better, and some may experience full-fledged financial crises. More than a dozen emerging-market economies now face severe financial pressures: Belarus, Bulgaria, Estonia, Hungary, Latvia, Lithuania, Romania, Turkey and Ukraine in Europe; Indonesia, South Korea and Pakistan in Asia; and Argentina, Venezuela and Ecuador (a country that has just defaulted on its sovereign debt) in Latin America.How is the policy response in the US and other countries to this risk of a global stag-deflation?The Fed decision yesterday to cut the target for the Fed Funds rate to a 0% to 0.25% range is just underwriting what was already obvious and happening in reality: while the target Fed Funds was - until yesterday - still1% in the last few weeks - following the massive increase in liquidity by the Fed - the actual Fed Funds was already trading at a level literally close to 0%.So the Fed just formalized what was already happening for weeks now, i.e. that the Fed Funds rate was already zero and that the Fed had already moved to quantitative and qualitative easing (QE) in the form of massive increase in the monetary base and aggressive use of monetary policy - via a range of new facilities and tools - to reduce short term and long term market rates that are stubbornly high in a sign that the credit crunch is severe and worsening.
I predicted early in 2008 that the Fed Funds rate "would be closer to 0% than to 1%" in the midst of a severe recession. Now 12 months into this severe recession (that officially started in December 2007) - a recession that will last at least another 12 months (if not, as possible, much longer) - the Fed Funds rate is already down to 0% (the beginning of the zero-interest-rate-policy or ZIRP for the US) and the Fed has moved into uncharted unorthodox monetary policy as a severe stag-deflation is taking place.And, as predicted here over a month ago, the Fed is now committed to keep the Fed Funds rate close to zero for a long time (as a way to push lower long term Treasury yields), is purchasing agency debt and agency MBS in massive amount; and is even considering purchasing long-term Treasuries as a way to push lower long term government bond yields that are already falling sharply.More aggressive policy actions may be undertaken by the Fed as a severe credit crunch shows no signs of relenting.

In his 2002 speech on deflation the Bernanke spoke even of helicopter drops of money, monetizing fiscal deficits, and even buying equities. The latter actions have already been partially undertaken: the Fed is effectively already monetizing the US fiscal deficits as the purchase of markets assets (agency debt and MBS and other facilities) is financed with the Fed printing presses rather than the TARP program; and now with the Fed considering the purchase of long term Treasuries such monetization of deficits will be made more formal. Also, since the TARP has been turned into a program to recapitalize financial institutions (and thus boost their capital and market value) the U.S. has already effectively intervened indirectly in the equity market (by partially nationalizing a good part of the US financial system); once the Fed starts to buy the US long term Treasuries financing the TARP program this indirect Fed purchase of U.S. equities will be even more clear.While Fed actions to reduce mortgage rates – via purchases of agency debt and agency MBS – are partially successful as long term mortgage rates are falling most of Fed purchases of private assets have been so far limited to very high grade securities. Thus, the gap between the yield on high grade commercial paper purchased by the Fed and the one that the Fed is not purchasing is sharply rising; ditto for the gap between agency MBS and private label MBS; also while long term Treasury yields are sharply falling the spread of corporate bonds – both high yield and high grade – relative to Treasuries remains huge as a sign of a severe credit crunch.

Thus, as a next step the Fed may be soon forced to walk down the credit curve and start buying private short-term and long-term securities with lower credit rating. That would mean that the Fed will take on even more credit risk than is already taking on today while purchasing illiquid private assets. But desperate times lead to desperate actions by desperate policy makers.In the rest of the world monetary and fiscal easing is also occurring as global policy makers are trying to prevent a global stag-deflation; but the policy response in most countries is more limited and constrained than the aggressive one of the US monetary and fiscal authorities.In the Eurozone the policy response has been extremely slow.

First, the ECB is behind the curve and cutting rates too little and too late. Second, the ECB has been much less creative and aggressive than the Fed in creating new facilities to unclog the liquidity and credit crunch that is becoming as severe in Europe as in the US. Third, the fiscal policy stimulus in the EU is weak: those countries that need a stimulus the most (Italy, Portugal, Greece, Spain, UK) are the ones that can afford it the least given their large fiscal deficits and debts; and those who can afford it the most – Germany – are least willing to have it. Fourth, the recapitalization of financial institutions in Europe is occurring more slowly than in the US and some of the financial firms rescue plans have been partly botched. Also, cross-border financial activities and the lack of cross-border burden sharing in the EU limit the ability of the EU to rescue large financial firms with cross-border activities. Add to this the fact that many banks in Europe are too big to fail but also too big to be rescued (large relative to the fiscal resources of their country’s government). Fifth, the structural rigidities of Eurozone (labor markets in particular) may cause the Eurozone contraction to be as severe as the U.S. one even if the initial economic and financial imbalances were less severe in this region.While the US and Japan are already into a ZIRP policy other advanced economies’ central banks will in 2009 get very close to it, starting with those in Switzerland and the UK. And more unorthodox monetary policies, such as QE and the other ones adopted by the Fed, may become more popular in a number of advanced economies.In the many emerging market economies at the risk of a financial crisis aggressive monetary easing and fiscal easing are not likely. Indeed, many of these countries start with large fiscal deficits and debt, thus requiring fiscal discipline rather than easing.

Moreover, many of these countries have large stocks of foreign currency liabilities whose real value would sharply increase if easy monetary policy leads to a sharp depreciation of their currency. Thus, there is less room for monetary easing. Also, many of these countries don’t have the fiscal resources to provide liquidity and capital to their financial institutions that are now facing a sudden stop of capital inflows. The international community – IMF programs, World Bank other IFIs financial support, and the Fed/ECB with their swap lines – can help countries under distress as long as they implement appropriate policy changes but the risks of outright financial crises remain in some of the weakest economies.In China – that is now at risk of a severe hard landing - it is not clear whether the aggressive fiscal and monetary/credit easing will be able to prevent a hard landing. Can aggressive monetary/credit and fiscal policy easing prevent this hard landing?

Not necessarily. First note that China has already reduced interest rates three times in the last few months and easing some credit controls. But monetary and credit policy easing may be ineffective: if capex spending by the corporate sector will start to fall sharply as the fall in next exports leads to a sharp fall in the expected return on new capital spending on exportables a reduction of interest rates and/or an easing of credit controls will make little difference to such capex spending: easing money and credit will be like pushing on a string as the overinvestment of the last few years has led to a glut of capital goods. There is indeed already evidence that but corporate loan demands have diminished sharply while commercial banks have hesitated to lend while choosing to firewall risks. The government can ease money and credit but it cannot force corporate to spend and banks to lend if loan demand is falling because of low expected returns on investment.Could fiscal policy rescue the day and prevent a Chinese hard landing?

The optimists argue yes by pointing out that fiscal deficits and public debt are low in China and that China has the resources to engineer a rapid fiscal stimulus in a short period of time. But the ability of China to implement a rapid and massive fiscal stimulus is limited for a variety of reasons. First, the combined effects of natural disasters, social strife in the West, and the Olympics have created a large hole in the central government budget this fiscal year. The Ministry of Finance may have dipped into various stabilisation funds to avoid the appearance of running a large deficit. For regional and municipal governments, the decline in turnover in local property markets has reduced the flow of fees and taxes, causing them to delay ambitious industrial development plans in some cases. Second, a hard landing in the economy and in investment would lead to a sharp increase in non-performing loans of the – still mostly public – state banks; the implicit liabilities from a serious banking problem would then add to the implicit and explicit budget deficits and public debt.
Note that the poor quality of the underwriting by Chinese banks –that financed a huge overinvestment in the economy - has been hidden for the last few years by the high growth of the economy. Once net exports go bust and real investment sharply falls we will see a massive surge in non-performing loans that financed low return and marginal investment projects. The ensuing fiscal costs of cleaning up the banking system could be really high. Third, as pointed out by Michael Pettis – a leading expert of the Chinese economy – a surge in tax revenues in last 4 years has been more than matched by surge in spending so that if revenue growth diminishes/reverses it might not be easy to slow spending growth proportionately.

Contingent liabilities from non-performing loans could also reduce resources available for a fiscal stimulus.In summary, with traditional monetary policy becoming less effective, non-traditional policy tools aimed at generating greater liquidity and credit (via quantitative easing and direct central bank purchases of private illiquid assets) will become necessary in many advanced economies. And while traditional fiscal policy (government spending and tax cuts) will be pursued aggressively, non-traditional fiscal policy (expenditures to bail out financial institutions, lenders and borrowers) will also become increasingly important in these advanced economies.

In the process, the role of states and governments in economic activity will be vastly expanded. Traditionally, central banks have been the lenders of last resort, but now they are becoming the lenders of first and only resort. As banks curtail lending to each other, to other financial institutions and to the corporate sector, central banks are becoming the only lenders around.Likewise, with household consumption and business investment collapsing, governments will soon become the spenders of first and only resort, stimulating demand and rescuing banks, firms and households.The long-term consequences of the resulting surge in fiscal deficits are serious.

If the deficits are monetized by central banks, inflation will follow the short-term deflationary pressures; if they are financed by debt, the long-term solvency of some governments may be at stake unless medium-term fiscal discipline is restored.Nevertheless, in the short run, very aggressive monetary and fiscal policy actions — both traditional and non-traditional — must be undertaken to ensure that the inevitable stag-deflation of next year does not persist into 2010 and beyond.