Fed Watch: Denying the Great Adjustment

Tim Duy's latest Fed Watch looks at growing international imbalances that have "US and emerging market policy makers on a collision course":

Denying the Great Adjustment, by Tim Duy: While not always the dominant force in my outlook, the external imbalance consistently lurks in the background of the US economy. I tell local audiences that the imbalance represents a very simple reality – the US consumes more than it produces, and the excessive consumption is provided by foreign producers. Eventually, maybe tomorrow, maybe years from now, those producers will desire to consume their own domestic output. At that point, US consumption and production will have to fall into line via a possibly painful restructuring. The more painful, the more policymakers will resist.

It is interesting to reference this framework in light of recent policy talk, kicked off by Federal Reserve Vice Chair Donald Kohn:

..in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.

Next up was Lawrence Summers, former Secretary of the US Treasury:

Third, policymakers need to make a clear commitment to addressing the non-monetary factors causing inflation concerns. Though this could change rapidly and vigilance is necessary, it does not now appear that there are embedded expectations of a continuing wage price spiral. Rather, the primary source of inflation concern is increases in the price of oil, food and other commodities. Even if structural measures to address these issues do not have an immediate impact on commodity prices, they may serve to address medium-term inflation expectations. Appropriate steps include reform of misguided ethanol subsidies that distort grain markets to minimal environmental benefit, allowing farm land now being conserved to be planted; measures to promote the use of natural gas; and reform of Strategic Petroleum Reserve Policy to encourage swaps at times when the market is indicating short supply. Major importance should be attached to encouraging the reduction or elimination of energy subsidies in the developing world.

Unlike Kohn, Summers dances around the monetary causes of inflation, and engages in some domestic policy criticism, but puts “major” importance on reducing energy consumption in emerging markets. Finally (at least from the US), we have Federal Reserve Governor Frederic Mishkin:

One important factor behind developments in recent years has been the rapid growth in emerging market economies such as China. On the one hand, rapid growth in Asia has stimulated strong increases in import demand, cushioning the slowdowns in the United States, Europe and Japan, but on the other hand, the rapid growth in demand has pushed up prices for commodities that are in short supply. Thus, inflation rates in many emerging economies have risen sharply. The central banks in most parts of the world are at a crucial juncture: We must all be vigilant to keep inflation expectations anchored and inflation low.

Mishkin is a bit more charitable than Kohn, noting the benefits of strong growth abroad, but clearly lays the blame for inflation at the feet of emerging market economies. Notice, then, the dominant policy theme that lies at the heart of all three speakers: The rest of the world needs to grow at a slower pace so that the US can grow at a faster pace. This is not a surprise, as US policymakers are unwilling to accept what Yves Smith sees as the inevitable result of years of debt-supported consumption growth:

Perhaps I am lacking in imagination, but I see lower living standards for Americans an unavoidable outcome. We're seeing it now, via rising food and energy costs with stagnant wages. If you were to describe what ails this economy in its most fundamental terms, we have gone on a borrowing binge to support an unsustainable level of consumption. Merely having consumption fall to a healthier level would precipitate a slowdown. And that's before we get to the problem of "and what do we do with the debt hangover?"

Domestic policymakers are resisting, both via monetary and fiscal stimulus, and more will be coming. Interestingly, foreign policymakers continue to support US profligacy, making the comments of Kohn, Summers, and Miskin all the more ironic. As Brad Setser reports, it looks like foreign central banks are accumulating dollar reserves at a pace that more than finances the US current account deficit, even overflowing the US with money:

If most of the increase in dollar holdings finances the US (not foreigners borrowing in dollars), then the official sector provided enough money to the US not just to cover the current account deficit but to finance an outflow of private capital.

While Kohn et al., are bemoaning monetary policy abroad, that policy is keeping the US awash in capital at a critical juncture. Think of the asset boom that would occur should that capital actually gain some traction.

But wait – that capital is gaining traction, but in such a way that forces the inherit overconsumption of the US economy to light. Pick a channel, speculative investment, portfolio rebalancing, or fundamental demand, and you find financial markets trying to drive a rebalancing by forcing up the cost of key commodities. What US policymakers are unwilling to allow directly, the markets are forcing indirectly.

Consider that the current account deficit will need to correct by some mixture of import compression and export expansion. The weaker Dollar encourages that correction, but Dollar-pegs prevent the full adjustment. But where currency adjustment fails, commodity price adjustment steps in as, for example, higher transportation costs support import competing industries. Indeed, we are learning that cheap oil, not just cheap wages abroad, was the critical force supporting offshoring of US production.

On the consumption side, higher commodity prices reduce real demand growth. Note that this is likely a better adjustment mechanism that the alternative of abandoning all policy support and letting unemployment soar. Arguably, the pain of adjustment is spread throughout the economy rather than concentrated among the unemployed. But one should not forget the important distributional impacts of allowing higher commodity prices to force the consumption adjustment. In particular, lower income families are more energy intensive relative to high income families, so the adjustment is regressive, a point made by Robert Reich. And among manufacturers, the US auto industry suffers disproportionately.

I have long maintained that this adjustment should be characterized by weak consumption growth but better-than-expected business activity overall, particularly in export and import-competing industries. Effectively, the US is offshoring some of its weakness. The combination should be something that consumers clearly associate with recession, but with better than expected output, especially when policy stimulus is added to the mix. This is very much like the current environment, a recession that still lacks a single quarter of negative GDP growth. But the level of stimulus is starting to look excessive, and supporting a more inflationary environment than anticipated.

How long can this process continue? As long as global policymakers are willing to support it. Indeed, it is almost of a game of chicken, with US and emerging market policy makers on a collision course, neither wanting to accept the adjustment, a greater reliance on internal balance, necessitated by excessive US consumption.

The US is not likely to back down soon. We are seeing increasing calls for additional stimulus packages, and Brad DeLong is even suggesting the Democrats abandon any pretense of fiscal responsibility. The Federal Reserve is stuck, afraid to counter inflation via a rate hike themselves, instead exhorting foreign central banks – the very banks keeping the US afloat – to provide space for greater US growth at the expense of their own. In the meantime, the Dollar turns lower and oil sets a new record seemingly each month. Breakeven on the 10 year TIPS tested 260bp today, settling at 259. With US policy stuck in place, I suspect that emerging markets will take only baby steps toward changing the current dynamic. That leaves the ECB as the force most obviously leaning against the wind. Indeed, until inflation becomes sufficiently uncomfortable that a broader swath of nations finds meaningful policy tightening a necessity, I expect current financial trends to continue.