By Nouriel Roubini | 20 December 2008
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While it is now fashionable to talk about such deflationary risks (and the latest U.S. Consumer Price Index figures confirm that we are entering into deflation) some of us were worrying about the coming deflation well before the mainstream— concerned with short-run and unsustainable increases in commodity prices— discovered the deflationary risks in the global economy. It was clear to those who saw, early on, the risks of a severe U.S. and global recession, that deflationary rather than inflationary pressures would emerge alongside a slack in goods, labor and commodity markets. Welcome to the world of stagdeflation or, as Paul Krugman would put it, the world of "depression economics."
So what is the outlook for 2009? And what is the likely policy response to the risks of a global stagdeflation?
The outlook for the U.S. and the global economy is now very bleak and getting worse as the global economy experiences its worst recession in decades. In the U.S., recession started last December and will last at least 24 months— until next December— the longest and deepest U.S. recession since World War II. The cumulative fall in gross domestic product may well exceed 5%.
In comparison, the last two recessions in 1990-91 and 2001 lasted only eight months each and the cumulative fall in GDP was only 1.3% and 0.4%, respectively. There is also a risk that this deep and protracted U-shaped recession may morph into a more severe Japanese style L-shaped recession unless aggressive fiscal policy and recapitalization of the financial system is enacted. (The former mainstream consensus view of a 'V-shaped, short and shallow' recession is now far out the window.)
The recession in other advanced economies (the euro zone, the U.K., other European economies, Canada, Japan, Australia and New Zealand) started in the second quarter of this year, before the financial turmoil in September and October further aggravated the global credit crunch. This contraction has become even more severe since then. I don’t expect growth in any of the advanced economies to recover before the end of 2009.
There is now also the beginning of a hard landing (growth well below potential) in emerging markets as the recession in advanced economies, falling commodity prices, and capital flight all take their toll on growth. Indeed, the world should expect a recession (growth in the -1% to -2% range) in Russia and a near recession (growth close to zero) in Brazil next year, owing to low commodity prices. There will also be a very sharp slowdown in China and India that will be the equivalent of a hard landing for these countries.
In China the latest figures for electricity use, exports and imports suggest that the economy is already close to the hard landing scenario of a growth rate of 5%. The deceleration of growth in China is much more rapid than expected. Other emerging markets in Asia, Africa, Latin America and Europe will not fare better and some may experience full-fledged financial crises.
More than a dozen emerging-market economies now face severe financial pressures: Belarus, Bulgaria, Estonia, Hungary, Latvia, Lithuania, Romania, Turkey and Ukraine in Europe; Indonesia, South Korea and Pakistan in Asia; and Argentina, Venezuela and Ecuador (a country that has just defaulted on its sovereign debt) in Latin America. What is the policy response in the U.S. and other countries to this risk of a global stagdeflation? The Fed decision to cut the target for the Fed Funds rate to the 0% to 0.25% range is just underwriting what was already obvious and happening in reality [[ie, the de facto rate has been replaced by the de jure: normxxx]]: While the 'target' Fed Funds rate was until Tuesday still nominally 1%, in the last few weeks— following the massive increase in liquidity by the Fed— the actual Fed Funds rate was already trading at a level close to 0%.
So the Fed just formalized what had already been happening for weeks now— that the Fed Funds rate was already zero and that the Fed had already moved to 'quantitative and qualitative easing' (QE) in the form of a massive increase in the monetary base and aggressive use of monetary policy to reduce short-term and long-term market rates that remain stubbornly high in a sign that the credit crunch is severe and worsening. I predicted early in 2008 that the Fed Funds rate "would be closer to 0% than to 1%" in the midst of a severe recession. Now, 12 months into this 'severe recession'— a recession that will last at least another 12 months (if not, as is very possible, much longer)— the Fed Funds rate is already down to 0% (the beginning of the zero-interest-rate-policy, or ZIRP, for the U.S.). The Fed has moved into uncharted, unorthodox monetary policy to offset the severe stagdeflation now taking place.
And, as predicted by me over a month ago, the Fed is now committed to keep the Fed Funds rate close to zero for a 'long time' [[— "as long as it takes": normxxx]] (as one way to push longer term Treasury yields lower). They have committed to purchasing agency debt and agency MBS in massive amounts, and 'are even considering' purchasing long-term Treasuries, directly, as a final way to push long-term government bond yields lower— that are already falling sharply. More aggressive policy actions may be undertaken by the Fed as the severe credit crunch shows no signs of relenting. In a 2002 speech on deflation, Ben Bernanke spoke of "helicopter drops of money," monetizing fiscal deficits, and even buying equities.
The latter actions have already been partially undertaken. The Fed is already monetizing U.S. fiscal deficits as the purchase of market assets is financed with the Fed printing presses rather than the TARP program. And now, with the Fed considering the purchase of long-term Treasuries, such monetization of deficits will simply be made more formal. [[Moreover, the "new fiscal stimulus", to be more than three times as much as the old, takes care of the "helicopter drops.": normxxx]]
Also, since the TARP has been turned into a program to 'recapitalize' financial institutions (and thus boost their capital and market value), the U.S. has already effectively intervened indirectly in the equity market (by partially nationalizing a good part of the financial system). Once the Fed starts to buy the long-term Treasuries financing the TARP program, this indirect Fed purchase of U.S. equities will be even clearer. While Fed actions to reduce mortgage rates— via purchases of agency debt and agency MBS— have been partially successful, inasmuch as long-term mortgage rates are falling— most of the Fed purchases of private assets have been so far limited to very high-grade securities.
Thus, the gap between the yield on high-grade commercial paper purchased by the Fed and the one that the Fed is not purchasing is rising sharply; ditto for the gap between agency MBS and private label MBS. Also, while long-term Treasury yields are falling sharply, the spread of corporate bonds— both high-yield and high-grade— relative to Treasuries remains huge as a sign of the severe continuing credit crunch. Thus, as a next step, the Fed may be soon forced to walk down the credit curve and start buying private short-term and long-term securities with lower credit ratings.
That would mean the Fed will take on even more credit risk than it is already taking on today while purchasing illiquid private assets. But desperate times lead to desperate actions by desperate policy makers.
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Nouriel Roubini, a professor at the Stern Business School at New York University and chairman of Roubini Global Economics, is a weekly columnist for Forbes.com.
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Normxxx
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