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Global recession challenge -- Wake up call for central bankers

V. Anantha-Nageswaran

``The Federal Open Market Committee decided today to lower its target for the federal funds rate by 50 basis points to 2 percent. In a related action, the Board of Governors approved a 50 basis point reduction in the discount rate to 1-1/2 per cent.

``Heightened uncertainty and concerns about deterioration in business conditions both here and abroad are damping economic activity. For the foreseeable future, then, the Committee continues to believe that, against the background of its long-run goals o f price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness.

``Although the necessary reallocation of resources to enhance security may restrain advances in productivity for a time, the long-term prospects for productivity growth and the economy remain favourable and should become evident once the unusual forces r estraining demand abate.

``In taking the discount rate action, the Federal Reserve Board approved the request submitted by the Board of Directors of the Federal Reserve Bank of Richmond.'' -- Board of Governors, US Federal Reserve Board

Economic weakness for `foreseeable future'

I HAVE highlighted two key phrases in the FOMC communication that accompanied the 50 basis point rate cut in the Federal funds rate and in the discount rate. The Fed believes that `for the foreseeable future' there is a greater risk of economic weakness than higher inflation. This is an unusually clear statement of anticipated economic weakness.

What is `foreseeable future'? The Fed normally makes forecasts for two years. So, one could take it that they are referring to 2002 and 2003. Even if it is referring to 2002 only, that still signals a longer period of weakness than is reflected in consen sus forecasts of US economic growth next year. Hence, this might prompt many to re-assess their forecasts of timing and magnitude of growth trough in the US and its subsequent recovery.

However, it clearly lays open the possibility of further rate cuts in December and in February. CSFB expects a 1 per cent Federal funds rate by Spring 2002. While the market is focussed on this angle alone, it has failed to grapple with the other side of the equation - pronounced demand weakness that would bring about a 1 per cent Federal funds rate. When investors begin to do so, equities would pull back.

Fed talking down productivity revival

The Fed also concedes now that productivity growth would be lower than expected due to security considerations. Thus, Mr Alan Greenspan has now begun to talk down productivity growth in his own mind and in the minds of investors. He is right to do, even if a trifle late. For, despite the somewhat impressive increase in third quarter non-farm productivity growth, underlying trends are likely to deteriorate in the near-term.

A key driver of rising productivity in the 1990s was the outsized growth in investment spending. Capital stock rose much faster than labour, leading to a rise in labour productivity. This has resulted in excess capacity. The chart shows that the rational isation of investment spending is far from over.

With investment spending likely to stagnate for a while, productivity growth that shows up in statistics will likely be a result of workforce reduction. That is not healthy productivity. It would not be a robust supply response to vigorous demand; rather , it would be a reflection of weak underlying domestic demand.

European central banks too boost liquidity

Since the rate cut was well anticipated, I view the FOMC statement as negative for corporate profitability and demand recovery in the US economy. However, it is difficult to say when the market will take cognisance of that. Chances are low that it would happen this week as investors would bask in the protection offered by the rate cut from the Fed, the ECB and the BoE.

The joint rate cut by the two Europe-based major central banks was an effective synchronised monetary policy statement, even if not pre-planned. This shows the extent of policy-makers' concern about underlying economic risks. Markets are ignoring it and concentrating on the liquidity effect, for year-end performance improvement. It is likely that they will continue to do until year ends.

The ECB also did the right thing by announcing a shift in the focus of monetary policy meetings going forward. The first meeting in the month will focus on monetary policy. This is good as it reduces the market expectation of a rate action in every meeti ng. The second meeting would focus on other issues.

Equity market implications

We might well finish the year on the current relatively buoyant note due to year-end window dressing considerations, liquidity availability and absence of corporate warnings on calendar fourth quarter profits. Therefore, it is possible that any sell-off occurs in the first quarter of next year.

This has a 70 per cent chance and there is only a 30 per cent chance of equity markets losing their confidence before the year ends. Of course, if there is another terrorist setback, all bets are off and in the current environment that cannot be ruled ou t either, unfortunately. It could also be the case that the war on terrorism goes badly for the US and more allies turn sour, leading to an increase in global fright and risk aversion.

Barring those possibilities, equity markets will continue their recent rebound into the year-end, in the wake of ultra-low cash and bond yields. The New Year will bring back a touch of sobering reality and more realistic assessment of corporate earnings for the year.

At this stage, therefore, the best strategy is to adopt a trading stance. That is what our colleagues in Investment Consulting are doing, with their equity recommendations on US and in other markets. The advice given by Ned Davis to his clients is well w orth remembering:

``Despite all this, I still see the indicator evidence as mostly neutral. Selling rallies and buying big weakness would be my advice as we wait for the indicator evidence to get more decisive..''

Currency and bond market implications

The euro had lost ground after the cut and so has the pound, against the dollar. The euro's drop is worrying and signals that the ECB has more work to do to win back credibility. However, the sterling against the dollar at levels below 1.44 is a buy with sterling corporate yields well above the US or Europe yields in the 2-5 year segment.

Both the euro and the dollar remain buys, however, against the yen. Unlike these two, Japan has no fiscal policy or monetary policy lever to pull, barring prayers, miracles and structural reforms. The last two seem scarce these days. At 120 to the dollar , the yen is likely to weaken as Japan acknowledges the consensus view of a depressingly large GDP contraction this year and its continuation for the next two years. Deflation makes the real contraction appear less worrisome than it actually is. In nomin al terms, the shrinkage in economic output is striking. It is a ticking time-bomb.

Some drastic reflation measures may be coming in the days ahead, from the BoJ, forced by the government. The Finance Ministry has, in any case, announced intention to sell the yen.

For other regional currencies in Asia, we need to study the impact of Indonesian aid relief from donor countries/agencies. However, that might only bring short-term relief to the currency, if at all. International climate has to improve on the terrorism front and more rapid asset sale must be seen, to turn confidence around.

Until then, the Indonesian rupiah will be under pressure and weaken. The Singapore dollar will also be subject to the same risk considerations. No permanent relief is in sight.

What about the economic implications

I have deliberately chosen to focus on short-term market implications of the rate cuts. The economic impact of the rate cuts is simply hard to fathom. In normal cycles, such low interest rates would trigger a sharp recovery sooner or later even leading t o overheating concerns in the not-so-distant future. The world is so steeped in excess capacity and deflation now that such worries are too remote to be entertained.

Demand weakness stems from several factors now and that makes the task of monetary policy to revive growth more difficult. Some say that excess capacity would be purged in months and quarters and some say, in years. Even within a reputed research house s uch as Morgan Stanley, there are divergent views. Only time can tell. There is no visibility now, especially since terror attacks are an added factor in the equation.

Policy makers cannot be passive and they are not. That is the only comfort, at this stage. The efficacy of their actions is more a matter of prayer now than of past economic relationships.

(The author is Regional Head of Investment Consulting in Credit Suisse, Singapore. The views are personal. Feedback can be sent to nageswar@singnet.com.sg)