Jewish World Review Nov. 26, 2002 / 21 Kislev, 5763
David R. Kotok
Lessons Learned at The Philadelphia Fed … and an update to our strategic outlook
http://www.NewsAndOpinion.com | It was in the Q & A session of the final panel at Friday's Philly Fed sponsored annual Policy Forum.
All day we had been hearing from and addressing questions to academics and central bankers about crisis, contagion and coordination. Then a questioner raised the specter of a Japan style deflation in the United States and asked how we can avoid it.
The moderator, Philly Fed President Tony Santomero, graciously offered his three central banker panel colleagues an opportunity to respond. All did. All stressed the importance of keeping one's monetary house in order.
San Francisco Fed President Bob Parry summed up the Fed's deflation avoidance policy.
1. "Act aggressively and I think we have."
2. "Act preemptively and I think we did."
Parry could have stopped there but he chose to nail the other important item:
3. "The zero inflation objective is not desirable."
That's what has changed in U.S. monetary policymaking. In the old days the Fed's inflation hawks wanted to reach zero. In today's new deflation risk days, zero has been moved to something higher. This is the new monetary cushion. There is no magical acceptable inflation number articulated by the Fed. They do not specify a numerical inflation target. Fed officials do refer to various measures of inflation for reference.
In our view the number "2" has become key. At the conference reception we discussed this with a famous Fed watcher, The Washington Post's John Berry. He thinks the number is "something between 1 and 3." Well "2" certainly qualifies. Other central bankers we've talked with also seem to accept that number "2" target.
We do. Our economic forecasts and market strategy operate with a 2% inflation baseline assumption.
Central bankers around the world are aware of the deflation risk and are determined to avoid it. for America's Federal Reserve position see Fed Governor Bernanke's recent speech; http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm.
Soon the European Central Bank will join in with a rate cut. They now have next year's inflation forecasts below their 2% mandated threshold. While each central bank must act in the interest of its own country or region, one thing seems clear: all central bankers agree that deflation must not be permitted.
What about Japan.?
Yasuhiro Maehara rose from the audience to address this issue. He represented the Bank of Japan at the Policy Forum.
Maehara acknowledged that Japan's current problem is structural. He distinguished between dealing with the bad loans of the past and dealing with the newer bad loans that their banking system has acquired because of the deflation. He admitted this needs a comprehensive program and outlined some details. And then he added his important contribution. Our government "realizes it must boost the economy and corporate rehabilitation and banks" he said. "It took too long to realize" but "now we are moving on these issues aggressively."
Cumberland's position is that the world will not morph into a global deflation. We believe the odds are now very high that we will see reflation on a global basis.
That means very low short term interest rates are with us for, at least, most of next year. It also means massive liquidity will slosh around the globe looking for resting places. And big liquidity pools mean volatile market movements.
This liquidity is good for stocks but will bring headwinds for bonds as the economy strengthens and the worldwide reflation gains traction.
For the last year we have been basing our portfolio strategy on the assumption that the benchmark ten year U.S. treasury bond yield has made a strategic bottom around the 4% level. We are affirming that opinion. Our bond portfolios reflect a defensive structure. We believe the longer term trend for bond interest rates will be higher, not lower.
The U.S. economic outlook for next year is improving. U.S. growth should strengthen and may reach toward 4% by yearend 2003. Very low short term interest rates will keep the auto and housing sectors from outright collapse even though they will slow because of declining demand. Capex will start to improve. So will defense/security sectors now that Congress has passed the President's security and terrorism agenda. Construction should improve now that terrorism insurance will be available.
The Unemployment Rate (UR) will probably rise into mid-2003. But we know that is a lagging indicator and its increase should not alarm us. We use the UR to guide us about when the Fed will start to raise rates. Our guess: 3 to 6 months after the UR has peaked.
Japan will stop sinking. And Europe will see much needed monetary stimulus from the ECB while simultaneously advancing the eastward expansion by admitting ten more countries to the European Union.
War and terrorism remain a serious threat and will be with us for a long time. But I have to believe we will prevail in this war even as occasional shocks occur.
The outlook for 2003 and 2004 is getting better.
We wish all our readers a pleasant holiday as we each give thanks in our own way for those fruits of freedom we hold dear and which enable us to live with enormous bounty.
Stay safe and have a good holiday.
11/22/02: What happens when you mix politics and municipal bonds