Monday, March 28, 2005

In his column at the end of last week, Stephen Roach once again proclaimed his belief that the tightening has finally begun in earnest. And yet the Fed cowboy on his trusty steed Federal Funds is chasing after a calf Inflation that is doing a good job of outrunning the cowboy himself.
Measured tightening is being largely offset by a measured increase in underlying inflation -- muting the impacts of the Federal Reserve�s efforts to turn the monetary screws. And it�s become a real footrace: The Fed tightened by 25 basis points on March 22, only to find that a day later the annualized core Consumer Price Index accelerated by 10 bp. In fact, the acceleration of the core CPI from its early 2004 low of 1.1% y-o-y to 2.4% in February 2005 has offset fully 74% of the 175 bp increase in the nominal federal funds rate that has occurred during the current nine-month tightening campaign.
But is inflation really that big a cause for concern? For January, PCE inflation is running at a 2.2% annual rate, hardly a run-away train. More recently, over the last three months PCE inflation is a quite tame 1.4% annualized, and that down from the annualized 1.9% rate of the last six months. Thus by this measure, we're looking at actual disinflation of late! High gas prices in March may change this trend, but there is a ways to go before PCE inflation again reaches an annual 2.0% over the short term (3-6 months). And the evidence suggests the Fed cares a lot more about PCE inflation than CPI inflation.

So even though I think Roach's obsession with inflation is overdone, I think he's right about the future direction of the Fed being inclined to end the tightening cycle long before we reach "neutrality" and the problems of the US current account deficit once again being forced through relative currency values than interest rates.
I still don�t think America�s central bank is up to the task at hand. In the face of disruptive markets or growth disappointments, this Fed has repeatedly opted to err on the side of accommodation. I suspect that deep in its heart, the Federal Reserve knows what�s at stake for the US -- and for the world -- if the asset-dependent American consumer were to throw in the towel. Unfortunately, that takes us to the ultimate trap of global rebalancing -- a realignment of the world that requires both higher US real interest rates and a weaker dollar. Should the Fed fail to deliver on the interest rate front, I believe that the US current-account correction would then be forced increasingly through the dollar. And that would redirect the onus of global rebalancing away from the American consumer onto the backs of Europe, Japan, and China. Call it a �beggar-thy-neighbor� monetary policy defense -- pushing the burden of adjustment onto someone else.
While the Eurpeans are getting a much-needed reprive on the euro, another attempt to surmount the $1.35 level can't be too far ahead. I just hope it happens after I've gone to Paris . . .

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