When 2006 began, all eyes in global equity markets were glued to the Federal Reserve. The U.S. central bank has always been a pivotal player in international financial markets, and foreign central banks and international investors are always keenly attuned to changes in U.S. monetary policy.
Although the U.S. economy may account for a smaller chunk of global GDP — because the rest of the world is growing faster than the U.S. economy — in other ways the U.S. has gained dramatically in importance in recent years. Thus, U.S. imports have more than doubled over the past decade, and account for around 18 percent of the world’s total exports. The U.S. continues to provide the bulk of global demand growth, on which many emerging economies, as well as export-dependent Japan and Western Europe, vitally depend.
Equally important, the U.S. has become a major supplier of capital via its yawning trade gap. In 1996, its trade deficit measured around $180 billion. It has now widened to around $850 billion. America is spewing an equivalent of nearly 1.5 percent of global GDP annually into the world financial system.
It can be plausibly argued that the rapid development of China’s industrial base would have been impossible without America’s willingness to run up massive current account deficits, the equivalent of 6.5 percent of its total GDP. Similarly, other Asian Tigers would not have been able to recover so strongly from the 1997-1998 regional financial crisis had it not been for the outflow of U.S. dollars, which allowed central banks around the region to build up huge speculator-proof hard currency reserves.
World stock markets had a spectacular 2005, which followed on the heels of a very strong 2004 as well. Emerging markets, as measured by the dollar-denominated MSCI index, gained nearly 40 percent of their value during the year. The Tokyo market rose by a similar margin when measured in yen. Europe also posted a strong performance, gaining around 25 percent in local currency terms.
But Wall Street provided a stark exception in 2005. The Dow Jones Industrial Average was flat, while the technology-dominated Nasdaq Composite index posted a very slight gain.
Why 2006 Was Much Better
The reason for America’s underperformance was not lack of growth — the U.S. economy was humming along nicely — but rather concern about the Fed. The central bank began raising its interest rates back in mid-2004, and was adding 0.25 percentage points with clockwork regularity after every Federal Open Market Committee meeting. The question troubling Wall Street was simple: How high would the rates go?
The rest of the world was also wary. The Fed provided plenty of liquidity for the rest of the global economy to enjoy heady growth, but was it now determined to take away the punchbowl?
It was no idle question. Global market indices were highly sensitive to every actual or perceived step by the Fed. Markets rose en masse in the first four months of the year, as Fed Chairman Alan Greenspan was preparing to retire, on hopes that the new regime would be more lenient. But in May, after the Fed hiked its rate yet again, investors became concerned that Ben Bernanke, the new broom at the Fed, would need to sweep even harder to establish his inflation-fighting credentials and might sin on the side of excessive tightness. Investors were spooked, and global stock markets plummeted. Some previously hot emerging markets, such as Turkey, Russia and Brazil, were swamped by bears, losing 20 percent to 25 percent in a matter of days.
But the Fed did pause at mid-year, after 17 straight interest-rate increases which pushed its Fed funds target rate from 1 percent to 5.25 percent during the previous 24 months. By mid-November, most markets around the world, even the hardest-hit ones, regained their May highs, and the Dow, having risen around 15 percent trough to peak, shot past the 12,000 mark during October.
A Goldilocks Economy
As 2006 was growing to a close, a seldom-seen fairytale condition seemed to be descending upon the U.S. economy, which stock investors love and which economists half-derisively call the Goldilocks economy — not too hot as to spur additional interest-rate increases by the Fed, yet not too cold as to prevent continued profit growth and stock market appreciation.
The most extraordinary development of the past year, in fact, has been the persistent lack of consumer price inflation. Even when oil and non-oil commodity prices rocketed to new records, and fears of supply disruptions pushed gasoline prices in the U.S. above $3 per gallon at the height of the summer driving season, the consumer price index refused to follow producer prices higher.
The economic environment has clearly changed from the 1970s, when a similar spike in oil prices created an unstoppable inflationary spiral. Now, a highly competitive market environment at all levels precluded price increases and forced producers to control other costs rather then pass higher commodity and energy prices and transport fees onto their customers. Moreover, a 20 percent decline in crude prices from their peaks in July-August promptly translated into lower prices at the consumer level — once again thanks to relentless competitive pressures.
Nevertheless, the Fed was probably right in showing concern over inflation in 2004, since it helped calm bond investors and prevented a yield spike in the bond market when oil prices were rising. By late 2006, bond markets were signaling that the Fed had done quite enough to battle inflation. The yield curve in the Treasury market became steeply inverted, with the yield on the 10-year bond falling to 4.57 percent in mid-November. The yield curve also became inverted in Europe, suggesting that there is little additional room for major central banks to keep tightening.
Falling bond yields have been like icing on the cake. The tightening by the Fed has taken the real estate market off the boil just as it became overbought and was entering a speculative stage. House prices have fallen quite sharply in many parts of the country and realtors and builders have been warning that a slowdown in the market could stretch through most of 2007. But lower long-bond yields — and mortgage rates — are likely to provide a solid bottom for the market and help work out inventories of unsold properties.
Looking Good — or Too Good?
Low inflation can be confidently expected to endure into 2007 and beyond — even if oil prices spike again on political uncertainty in key oil-producing regions. If there are no nasty political surprises and oil prices remain stable or even decline, deflationary pressures may even emerge this year, despite continued strong growth.
Low inflation means that there will be no reason for world central banks, led by the Fed, to tighten the monetary spigot dramatically. In other worlds, the flow of international liquidity will continue, boosting corporate profits and providing a cushion against financial disruptions. The funds that the U.S. continues to channel abroad, to developing countries in Asia, Latin America and elsewhere, will also provide plentiful investment capital to expand production capacities and increase output — further reducing inflation pressures.
A friend of mine, a banking sector analyst at Standard & Poor’s, exclaimed recently when talking about dramatic profit growth in the U.S. banking sector: “There is just so much damn money around!”
And that could be the real problem with this rosy scenario. Too much liquidity is not, ultimately, a good thing. Inflation is dangerous not only because it destroys savings, but because it skews the signal contained in market prices, prompting buyers and sellers to make wrong decisions. One problem could be that plentiful and cheap capital sloshing around world markets has been far too forgiving of overinvestment — potentially creating overcapacity and laying the foundations for a future overproduction crisis.
Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York.