LIQUIDITY RULES

リンク: Roubini Global Economics (RGE) Monitor.

September 20, 2006

It's too soon to declare that the Fed has once and forever stamped out the inflation embers, but it's clear that the central bank has won the current battle.

The concern that consumer and producer prices would spiral upward while the Fed kept interest rates flat has been demoted, if not yet completely quashed, as a topical worry. The FOMC meets today and will likely declare that the price of money can remain as is. In sum, the debate that the liquidity unleashed in the recent past is about to show up in official inflation numbers is dead for the moment. But the thornier issues of deciding where all the liquidity went, where it will go, and what it means for future price trends remains alive and kicking.

In an earlier era, the hefty injection of liquidity into the U.S. economy that prevailed in the years after 2001 would have delivered more of an inflationary kick, as tracked by consumer price gauges. That hasn't happened, but the reason has as much to do with deft central banking as it does with disinflationary and even deflationary winds blowing in the global economy.

The rise of emerging market economies in recent years, as The Economist points out this week, has been a major force for keeping broad measures of inflation relatively contained. As the survey asserts, emerging nations have delivered both a fresh and healthy dose of cheap labor and cheap capital to the world economy to a degree that's unprecedented. In turn, prices for a number of goods and services, along with wages, have stayed lower than they might otherwise be in the U.S. and elsewhere.

The Fed and other central banks, as a result, have found it easier to keep interest rates lower and permit liquidity to rise higher than prudence might have allowed a generation ago. But while the liquidity production hasn't come back to bite the economy, it's had an impact. Where has all that liquidity been going? It's not obvious, if one looks at the broad measures of inflation, as yesterday's producer price index and last week's consumer price report remind. But rest assured, the extra money the Fed has so generously printed has gone somewhere.

In the late-1990s, inflation arguably showed up in stock prices, which ran skyward. When the equity market collapsed in 2001 and 2002, cash found a new home in real estate. The bull market in housing in particular is said to be a boom of unprecedented proportions. Of course, that boom is now in the process of unwinding.

Liquidity has also migrated into emerging market economies, which hold 70% of the world's foreign exchange reserves, according to The Economist's latest world economy survey. That's extraordinary for a number of reasons, starting with the fact that while the lion's share of the planet's reserves are in emerging economies, those nations represent less than 20% of the world's stock market capitalization.

Imbalances are all the rage these days, and that extends to the extent that a large chunk of the liquidity held by the likes of China and India has migrated back to the United States in the form of funding of the country's current account deficit via purchases of Treasuries and other assets.

If the past is any guide, however, excess liquidity is a transient form of capital. Expecting it stay put may be expecting the impossible. If so, what does the future hold when the liquidity seeks out greener pastures? It's a timely question these days as some of the liquidity starts to come out of real estate and the global economy seems poised for a downshift in growth. Thus the question du jour: Where will liquidity go next? Perhaps it'll flow back into real estate, or gravitate back to stocks, or work its way into the economy so that the general price indices start moving up after all. Or, maybe the liquidity will surprise everyone and foment repercussions that no one can yet imagine.

Fed Chairman Ben Bernanke is on record as saying that the world has been awash with a global savings glut. That glut has been helpful to U.S. monetary policy so far. After Bernanke and company are done celebrating today, perhaps they might ponder if the global savings glut will continue to benefit the American economy, or if something might change.

Posted by jp at September 20, 2006 09:24 AM