2002 November 09 Saturday
Stephen Roach Criticises European Central Bank

Morgan Stanley economist Stephen Roach thinks the US Federal Reserve's latest move and pronouncements indicate that the Fed is now treating deflation as a serious threat. By contrast, he finds much to fault in the ECB's recent failure to lower rates.

The problem with the ECBís approach is that it is completely out of step with the perils of deflation. While we forecasters live and die on the basis of our predictions, the policy maker cannot afford to bet on any one point estimate of the future. Like investing, policy setting is a business of probabilities. The ECB, like any central bank, must frame its actions in such a probabilistic context. Hereís, again, where the Fed anti-deflation script described above comes into play. According to this recipe, when the risks of deflation become significant -- say in excess of 25% -- the authorities must then treat such an outcome as their central case.

With 54% of the world already in the deflation zone and with Eurolandís fundamentals flashing a similar warning sign, I would argue that the ECB must now embrace the same risks that the Fed has adopted. In this climate, it can no longer afford the luxury of betting on the avoidance of deflation.

By contrast, Richard Berner and David Greenlaw, also of Morgan Stanley, think the threat of deflation is not receding, at least in the US:

But even if growth improves, the great deflation debate is still heated. "Core" producer prices declined in October from a year ago for the first time in the 26-year history of the data, and GDP price inflation has sunk to 40-year lows of 0.8%. We repeat our view: While deflation risks have risen, deflation enthusiasts err by looking at year-over-year headline inflation data (see "The Deflation Debate: Are Services the Next Leg?" Global Economic Forum, October 18, 2002). More recent inflation data, especially those purged of the decline in energy prices from a year ago, evince stable inflation. For example, the price index for gross domestic purchases excluding food and energy has been roughly stable for the past two years at 1 1/2%. Likewise, inflation expectations and forward-looking cyclical inflation indicators point to inflation stability. Nonetheless, global economic slack and a still-strong dollar will likely keep inflation hovering near 40-year lows.

As further proof, perhaps the strongest indication that deflation risks are mostly in the past comes from large-capitalization companies: Despite the mantra of no pricing power, Corporate America is racking up modest gains in revenue and much bigger increases in earnings. For example, with 86% of S&P companies reporting for the third quarter, earnings rose by 12.3% from a year ago on the back of a 3 1/2% rise in revenues. To be sure, earnings and revenues are below their previous peaks. And this rebound follows the biggest earnings bust in 50 years -- and the only decline in top-line revenues in the history of the data. But the results strongly suggest that operating leverage is now working to the upside, and that the benefits of financial deleveraging are beginning to help corporate cash flow.

Share |      By Randall Parker at 2002 November 09 02:32 PM  Economics Political


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