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Thursday, November 10, 2005

William Poole: A Hard Landing is Unlikely

St. Louis Fed president William Poole looks at the the likelihood that growing global imbalances will cause a hard landing for the U.S. His view is that so long as the U.S. pursues sound monetary and fiscal policy, a hard landing is unlikely. The reason, Poole argues, is that any adjustment is self-limiting because the U.S. is in the unique position of having most of its debt denominated in dollar terms rather than in a foreign currency and this changes the equation relative to a typical financial crisis. That is, because 95% of U.S. debt is denominated in dollar terms, a declining dollar will not increase the U.S. debt obligation to any substantial degree and thus will not precipitate a crisis. In addition, because the majority of U.S. assets held abroad are denominated in foreign currencies, these investments appreciate in dollar terms as the dollar declines further undermining the chance of a hard landing:

How Dangerous Is the U.S. Current Account Deficit?, by William Poole, St. Louis Fed President: The U.S. current account deficit has attracted considerable attention from academics, policymakers and market participants. So also has the U.S. international investment position—the difference between U.S.-owned assets abroad and foreign-owned assets in the United States. The net position has become increasingly negative as current account deficits have accumulated over time. ... [A] situation in which the U.S. net international investment position becomes ever more negative as a percentage of GDP is inconsistent with long-run equilibrium. So, the question is not whether the U.S. current account deficit will fall in the future but whether the inevitable adjustment is likely to be painful and disruptive of U.S. economic growth and stability—a hard landing. My answer is that a hard landing is very unlikely provided that U.S. monetary and fiscal authorities maintain sound policies. ...

It is sometimes said that the United States has become a “net debtor” nation, and that this situation increases the risk that currency depreciation might lead to financial crisis. Indeed, ... some have drawn comparisons with countries such as Argentina, Brazil, Mexico and other countries that at times have experienced severe balance-of-payments crises. I consider it highly unlikely that such a crisis will befall the United States. ... In fact, about 95 percent of international claims on the United States are denominated in dollars. A country with most of its debt denominated in its own currency is in a very different situation from one whose debt is denominated in other currencies. The familiar crises experienced by several Asian countries ..., by Mexico ..., and by numerous other countries have all involved situations in which the impacted countries have had large external debts denominated in foreign currencies. ... Consider what typically happens to a country suffering a balance-of-payments crisis. As the foreign exchange value of its currency depreciates, the value of its foreign liabilities ... increases, as does the burden of servicing its international debt. Recognizing this implication of a crisis, international investors respond by paring back their positions further, engendering even greater currency depreciation. Hence, the combination of foreign-denominated debt and a depreciating currency has proven to be something of a vicious circle—compounding and accelerating a crisis.

The U.S. situation is completely different. To the extent that the foreign exchange value of the dollar declines, ... Dollar-denominated U.S. liabilities remain unchanged in domestic value, which means that debt service in dollars and relative to the size of the U.S. economy does not change. Moreover, holdings of U.S. investors abroad, about two-thirds of which are denominated in foreign currencies, appreciate in dollar terms. The composition of the U.S. international investment account, therefore, contributes to stability rather than to instability. ... If the capital markets view is correct—and I obviously think it is—the ... transition to a sustainable long-run path [will not] necessarily require wrenching adjustments in domestic or international markets or in exchange rates. ... The United States has created for itself a comparative advantage in capital markets, and we should not be surprised that investors all over the world come to buy the product.

Finally, for those looking for a statement about the future course of interest rates, Bloomberg reports remarks made after the speech:

Federal Reserve Bank of St. Louis President William Poole said the risk of inflation is still ''skewed toward the high side'' after 12 consecutive interest- rate increases. ... ''I would put a higher probability on an upside surprise than on a downside surprise,'' he told reporters today following a speech... ''That in my mind calls for the Federal Reserve to make sure that policy is risk-averse with respect to that outcome.'' ...

And Cleveland Federal Reserve Bank President Sandra Pianalto, as reported by Reuters, remarked after her speech today (discussed here):

The Federal Reserve does not have a set goal for how high it wants to push up short-term U.S. interest rates and will be guided by economic conditions... "There is no numerical target because where ... we adjust it to ... depends on economic conditions," ... Pianalto... noted the Fed has been taking stimulus away from the economy... "Our statement says we are continuing to remove that accommodation," she said... "Where we determine we are no longer accommodative again depends on economic conditions." ... Pianalto also ... acknowledged ... that households could face a harder time servicing debts as rates rise. "As we start to see an increase in interest rates will that cause the consumer problems?" she asked rhetorically in response to a question. "I think it depends on whether that's gradual and how consumers adjust to that." "...we'll have to ... keep our eye on this situation as the conditions change," ...

    Posted by on Thursday, November 10, 2005 at 12:18 AM in Economics, Fed Speeches, International Finance, Monetary Policy | Permalink  TrackBack (0)  Comments (11)

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