Bare Talk observed last week that the Gulf Cooperation Council countries in their meeting on 3 and 4 December would take a decision on revaluation of their currencies against the US dollar. It said that while that was a domestic monetary policy decision, de-pegging had international ramifications and hence they would abstain from the latter. In the end, they refrained from both. Having thus got it wrong, Bare Talk will venture to predict the Federal funds rate decision of the American Federal Open Market Committee (FOMC) today.
Bare Talk narrows down its forecast to two alternatives: One is that FOMC cuts the Fed funds rate by 25 basis points and the discount rate by 50 basis points. The other is that FOMC cuts both the Fed funds rate and the discount rate by 50 basis points. Bare Talk assigns a higher probability to the first. Of course, there are other possibilities but Bare Talk believes that FOMC would not countenance them for fear of disappointing the financial markets too much.
Frankly, despite all the arguments for a Fed easing on Tuesday predicated on macroeconomic conditions, the case for an aggressive response boils down to appeasing financial market participants. The scope for sub-optimal decisions remains high because investors continue to live in a make-believe world that is now history but policymakers are doing little to disabuse them of that notion. This requires elaboration.
Last week, the US economic data was on the better side of expectations. In particular, a private sector survey of job creation that attempts to anticipate the strength of the employment report released by the government two days later (on the first Friday of every month) showed healthy job creation. Financial markets heaved a big sigh of relief. The data boosted hopes that recession would be avoided. In fact, employment data for November showed that, on average, the US non-farm economy added 100,000 jobs per month.
This is where financial market participants begin to want it both ways. They cheer stronger economic data, but do not accept the possibility that this should result in a higher path for the Federal funds rate, particularly since inflation is not tame enough for the Fed to ignore it. Or, to put it differently, expectations of an aggressive Fed easing today would be justified only if they did not believe the strong economic data to be sustainable. Actually, a convincing case can be made for that. Let us take the employment data. Reasonably strong jobs growth is not consistent with the rise in initial jobless claims (number of people filing to claim unemployment benefits for the first time), the rise in continuous claims (people continuing to claim unemployment benefits) and the reporting of deteriorating job availability in consumer confidence surveys. The US employment data are notorious for huge revisions over time that leave the final figure with little or no resemblance to the initial figures over which all arguments take place. Thus, one has reasons to be sceptical of the information content of monthly employment generation reports.
Accepting this logic would, however, lead to the realization that the outlook for American corporate profits is not rosy. But financial markets are picking and choosing the outlook they like. They believe strong data and they believe that the Fed should lower interest rates. This is inconsistent and confirms that all the developments of the last few months have scarcely dented equity investors’ indifference to risk. Worse, central banks, too, manoeuvre themselves into fostering such inconsistency and indifference.
This is beginning to cause greater problems to policymakers in developing economies. Even a cursory glance at inflation data in the last two months would show the inflation rate approaching double digits in many countries. In some cases, it is well into double digits. Quite a few policymakers appear reluctant to deal with it. Indonesia lowered the interest rate last week because inflation did not rise to 7% but inexplicably stood at 6.7%—almost the same as the rate that prevailed in the month before. This is dangerously myopic. China is realizing that belatedly. It is beginning to up the ante in its fight against asset and goods price inflation. The bank reserve ratio requirement would now go up by a full percentage point to 14.5% from February—the highest in 20 years. It might still be too late to avoid a hard landing for China’s economy and markets in the next two years.
Thus, as 2007 winds down and a new year approaches, we await the arrival of reality checks not just for investors but also for many central banks. Global financial stability has been put to risk by industry in the last few years and central banks are completing the task. The US Fed would show today that they are at it.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org