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Monday, May 05, 2003

Upbeat or Downbeat Fed?

Some commentators have been suggesting that the Fed is moving towards an increasingly upbeat message. Not everyone agrees. My own feeling is that while rates will remain monotonously unchanged across the globe this week, we are more likely to see the Fed funds rate move down again before we see it move up. The ever-perceptive Stephen Jen seems to agree:

Output gap is the key concept

Equity investors tend to focus on the trajectory of the nominal GDP growth path, while bond investors are more concerned about the size of the output gap (i.e., expected inflation). This disparity creates a situation where, if the expected growth rate of the US economy is between zero and the potential growth rate, then it is possible that equity investors are encouraged to hold more equities, while bond investors don’t sell bonds, thinking that deflationary pressures will continue to build. This interpretation is consistent with the diminished negative correlation between bonds and equities, that even though equities have rallied recently, bonds have not sold off much. It is also consistent with the message in Chairman Greenspan’s statement yesterday that, though there are signs of growth in the US economy, disinflationary pressures persist. In other words, Chairman Greenspan was, in my view, more cautious than he was optimistic, and may believe that growth is not likely to exceed potential growth rate anytime soon to choke off disinflationary pressures. The essence of the ‘double dip’ debate really hasn’t changed after the end of the war. The key question is still about capex: has enough capacity been shed that business investment will resume to justify high private consumption? I am not as optimistic on the outlook of the US and the global economy, and believe that any surge in equities will eventually fade as equity investors realise that things are not as good as they are hoping to see.
Source: Morgan Stanley Global Economic Forum

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