Saturday, August 02, 2003

Stephen Roach is preaching fire and brimstone again this Friday.
It�s a nightmare scenario, even for me. Sharply rising real long-term interest rates are the last thing an economy on the brink of deflation needs. Such an outcome would depress an already weakened state of aggregate demand, conjuring up notions of the dreaded deflationary spiral. The extraordinary correction in the bond market over the past seven weeks tells us not to dismiss such a possibility out of hand. . . .

long-term US interest rates are now on the rise -- and not just in nominal terms but even more so in real terms. After hitting a low of 1.6% in September 2002, the inflation-adjusted yield on 10-year Treasuries currently stands at around 3% (nominal yield of about 4.5% as of the July 31 market close, less a core CPI inflation rate of 1.5% y-o-y). Moreover, with core inflation having slowed to just 0.9% in the first six months of 2003, the risk to real long-term interest rates remains very much on the upside -- even if nominal yields don�t back up further. That risk hints at the toughest outcome of all -- the potentially lethal combination of low and falling inflation in conjunction with a back-up in nominal interest rates. Needless to say, should America�s current-account adjustment begin in earnest as the US continues to slide down the slippery slope toward deflation, the real interest rate outlook could be exceedingly treacherous. And that would be terrible news for a nascent recovery in the US economy -- raising the risk of a relapse in the interest-rate segments of aggregate demand that could lead to an intensification of disinflation and an even sharper back-up in real rates. It would be the ultimate vicious circle for US economy that is already close to the brink of deflation.
Not exactly time to get out the "economic recovery" party hats just yet, eh?

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