Cutting interest rates to record lows was necessary to prevent the complete collapse of the financial system and the real economy, but keeping them low for too long could also delay the necessary adjustment to a more sustainable economic and financial model ... they may still need to tighten monetary policy sooner than consideration of macroeconomic prospects alone might suggest.”
Fiscal consolidation may actually be necessary at this point but the call for monetary tightening into an environment of rising deflation risks is a little nutty.
DEFLATION THE PRIMARY RISK AHEAD
The weekend press was filled with stories of dramatic restraint still coming out of the State and local government sector, and not just to deal with huge budget deficits but also massive unfunded pension liabilities. For one example of how deep the cuts are, see Facing Deficit, Oakland Puts Police Force on Chopping Block (this is happening in one of the country’s most crime-laden cities). And in today’s FT, also have a look at this article on the matter – U.S. State Budget Crises Threaten Social Fabric.
Pressures are building in Washington to start exercising some fiscal prudence too, though there is little sign that the White House is listening. But as we saw last week with the failed attempt to pass yet another extension of jobless benefits, it is Congress that legislates, not the Administration. And there are other pressures building from within – just have a read of U.S. Deficit Proved Key to Orszag Departure on page 3 of the weekend FT.
The trend back to fiscal probity is gaining popularity. We see it in Canada and look what is happening in the U.K. – talk about resolve if the budget austerity measures actually see the light of day (Mr. Osborne considers himself to be a modern-day Maggie Thatcher). The Germans are turning a deaf ear to President Obama’s calls for more stimulus. Japan is set to double its consumption tax rate. The Club Med countries have no choice but to undergo dramatic retrenchment – either that, or face default.
This move towards fiscal restraint has triggered no shortage of complaints from the neo-Keynesians, but the reality is that 80%-plus debt-to-GDP ratios are a real game changer in the industrialized world. You reach a point of diminished returns, and we are likely at that point. And at a time of a sputtering recovery, fiscal belt-tightening will likely intensify global deflation pressures – with the risk that the deflation itself will impede, though not necessarily reverse, the move towards fiscal rectitude.
Nobody ever said deleveraging cycles were painless events. Just read Rogoff and Reinhardt, or the McKinsey report for that matter. Also have a read of a shorter “take” on what is coming down the pike; on page 16 of the weekend FT – Spectre of Deflation is Back to Haunt Investors.
In a deflation environment, income is king. Two articles come to mind from our weekend reading: Dividends Are Back on page B7 of the weekend WSJ and Muni Bonds: Don't Hit the Panic Button Yet on page B8.
For the dividend theme, after a hiatus in 2009, this strategy has really taken off with the U.S. stock dividend index up 1.9% year-to-date while the overall market is down 2.5%. So far in 2010, the good news is that income-seeking equity investors have seen 136 of the S&P 500 companies raise their payouts, or initiate new programs, while only two have cut or suspended theirs. After a net cut of $37 billion in payouts last year, dividend payments have rebounded $11 billion so far in 2010 (there is more on this theme too on page 5 of the Sunday NYT biz section -- Dividends Are Rising: Will Stocks Follow?).