The biggest risk to global markets

The US government's fiscal stimulus package is unlikely to work, which means it is up to the Fed to stablise the US economy - and the financial markets.
A consensus has been formed among US political and monetary authorities on the need for a temporary fiscal boost to help the economy avert a recession. Meanwhile, the US Fed is cutting interest rates.

In the past, such a combination of aggressive interest rate cuts and government efforts to boost economic activity has worked to pull the economy out of the doldrums. For example, during the Savings & Loan (S&L) crisis in the late 1980s and early 1990s, it was the combination of deep Fed rate cuts (by a total of 525bps, from 8.25% to 3%) and government intervention in the form of setting up the Resolution Trust Corporation that finally boosted public confidence, revived credit activity and spending, pulled the economy out of recession and delivered a stock bull market.

However, things are different this time. While the US financial system was crippled in the S&L crisis, it is not this time around. Notably, commercial and industrial loans are still growing (Chart 1). But the loss of confidence is crippling domestic demand growth, and the FedÆs indecisive policy is increasing the risk of an economic recession. Hence, the Bush administration is proposing a fiscal boost, endorsed by the Fed, amounting to $146 billion. The stimulus will chiefly come in the form of one-time tax rebates or cash handouts to the low-income and jobless groups to boost consumption.


The problem is that a temporary, one-off, tax rebate (or cash handout) will not boost demand as effectively as the politicians assume. This is because consumer spending is not really a function of current liquidity. It is more a function of ôpermanent incomeö, defined as an individualÆs expected life-time income stream. This so called ôpermanent income hypothesisö suggests that an individual would alter his/her spending habit only when his/her life-time earnings expectations change. Hence, when someone makes a windfall gain, they would not spend it all at once. Instead, they would keep their usual spending habit, save the bulk of the windfall or use it to pay down debt. Conversely, if someone loses his job, he would not cut spending at once. He would draw down savings or borrow money to keep the normal spending habit in the expectation of finding a new job soon.

President BushÆs proposed one-shot tax rebates will not alter peopleÆs ôpermanent incomeö. Thus, it will not boost consumption as expected. Most people will save the money, especially in times of economic uncertainty, or pay down debt. All empirical studies in the US show that one-shot tax cuts were ineffective in boosting demand during economic downturns (in 1975 and 2001). Those who thought the 2001 temporary tax rebates stimulated the economy missed the point that the rebates were part of a bigger fiscal package that contained long-term tax cuts, which changed peopleÆs permanent income expectations.

Under the current sub-prime-induced crisis situation, the savings incentive will overwhelm any spending motive when people receive the one-time tax rebates. Crucially, many more Americans have piled on debt in recent years. So, it is highly likely that most of the temporary tax rebates and cash handouts would be used to repay debt rather than to increase spending. This one-shot fiscal aid will be welcome, for sure. But it will not boost spending effectively. All this puts the ball back in the FedÆs court û the onerous job of stabilising the US economy still rests with the Fed.

The biggest risk to the markets
The problem is that the Fed has been lagging behind the curve. Even with the combined 125bp rate cuts on January 22 and January 30 (the latest FOMC meeting), it is still behind - albeit less so. The market-driven two-year US Treasury yield has dropped to 2%, compared to the 3% Fed Funds rate (after the 125bp rate cut) (Chart 2). This suggests that the Fed is still keeping short-term rates higher than those warranted by market conditions.


In fact, the major central banks have not engaged in reflation assertively. From the US Fed to EuropeÆs ECB and JapanÆs BoJ, their policy signals have either been indecisive or too stubborn, all because of their anti-inflation bias. Hence, the biggest risk to the global markets lies in the central banks. They are on the brink of committing the old policy mistake of being insensitive to the potential debt-deflation threat in the aftermath of the bursting of an asset bubble.

The good news is that, after repeatedly being pushed by the markets, the Fed is waking up to economic reality. The 75bp rate cut on January 22, and the 50bp cut that followed a week later, might be the start of an aggressive rate cut cycle, which could bring the Fed Funds rate down to 2.25% by mid-2008 (by my estimate). The FedÆs aggressive rate cuts hopefully will put pressure on the ECB to change its hawkish, and backward-looking (in my view), monetary stance soon. If the ECB remains stubborn about fighting the ôinflation phantomö, the epicentre of this financial crisis will shift from the US to Europe. This will prolong the turbulence in the global financial markets. But as and when both the Fed and the ECB move in the same direction to cut rates, that will clear the way for a new bull phase for stocks. Experience shows that aggressive rate cuts always ignite asset price inflation û leading to a new asset bubble, if you would.

Chi Lo is a research director at Ping An of China Asset Management (Hong Kong).
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