FUNDAMENTAL DISAGREEMENTS – HOW TO SAVE THE WORLD?

FERRIER INTERNATIONAL thanks Cees Bruggemans, Chief Economist of FNB for this article which we share with you.

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Fundamental disagreements

By Cees Bruggemans, Chief Economist FNB
17 March 2009

How to save the world?

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It is a fundamental question. But instead of growing convergence in thinking and policy prescriptions around the world, there appear crucial dimensions in which there is growing disagreement about what to do next.

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If such disagreement were to go too far, it could have fatal consequences.

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We note disagreements between central banks (serious), between governments (very serious), between academics (serious for future historians), between forecasters (serious for current reputations) and probably between husbands and wives (watching too much or too little telly, depending).

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Central banks seem to have started to criticize each other. There isn’t any blatant name-calling going on, but there seems to be this high-road low-road business, one party claiming we-will-do-this, with another saying quite succinctly we-will-never-do-that.

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Does it matter? It could.

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Anglo-Saxons, along with the Swiss (and Swedes), seem joined at the hip about taking interest rates down to near zero, and to move next to quantitative easing, described by some as basically credit easing.

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The aim is to get lending going again. In the case of the Swiss (and the Swedes), there is the additional aim of getting a strong home currency to weaken, protecting the home economy under increasingly dire circumstances.

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These central banks have lowered interest rates to near zero in the hope of pulling effective interest rates in the economy to low levels despite very wide spreads.

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It also has induced certain central banks to start making credit markets of their own (for commercial paper, auto loans, credit cards, student loans) where such markets have ceased to exist.

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As to quantitative easing, large quantities of fixed income bonds (publicly and corporate issued) are held in private institutional hands. By buying such bonds on a large scale, Anglo-Saxon central banks could be doing various things.

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They will drive up the price of such bonds, lowering their yields. And they will inject a lot of cash into the financial markets, increasing the cash holdings on banks balance sheets.

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With banks still very distrustful and not really wanting to lend out money to risky customers, but with bond yields still attractively high, any increase in their cash holdings would induce banks to buy more bonds.

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By reducing bond attractiveness (falling yields), while loading the banking system with cash (the Bank of England for instance wanting to expand the British monetary base very quickly by 80%), with no low-risk reasonable return investment alternatives available to them, the idea is to prompt banks to start lending again to more risky but also higher return borrowers.

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Initially, this won’t quite work as banks will prefer to safely hoard cash/liquidity rather than start lending. But as the cash mountain grows and grows (a rising tide), watch out for a gradual breakdown in hoarding as banks get pushed to do something with what is ultimately still relatively expensive cash.

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And so the Fed and BOE are starting to buy bonds, although there could be leakage.

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Many bonds are held by foreigners, and buying from them could inflate the cash deposits of their home banks, while putting downward pressure on one’s own home currency (Sterling, Dollar, Swiss Franc, Swedish Krona).

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Ideally, all major central banks would undertake such actions at the same time, neutralizing such leakage effects on each other, while collectively pumping up the global financial system.

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But the ECB specifically doesn’t want to go there, or so it is still saying today. Some of its leading elements see it more like an invitation of blowing up the world. Not for them, it seems.

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The Anglo-Saxons see the danger of Europe not repairing its credit-lending processes fast enough, becoming an ever greater drag on the world economy.

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The Europeans seem to fear too much money creation and new types of financial instability.

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This doesn’t seem to face the Anglo-Saxons. Credit has to start flowing again, and any involuntary unwillingness among private banks needs to be forcefully addressed.

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This is aside of bank capital adequacy needing to be improved and impaired (toxic, reduced-value) assets needing to be written down. This is being addressed separately through bank nationalizations (partial and otherwise) and public capital injections (which are issues for national treasuries and their governments to address, mobilizing their tax bases).

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In the short term, even more serious is the apparent difference between governments concerning their roles and what they need to do most urgently.

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Some (especially Europeans with some emerging markets in tow) want to focus on getting financial market regulations tightened as soon as possible (along with governance changes to international lending agencies).

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Others, especially Americans, seem to think this very important but not an immediate urgency (Heaven Can Wait).

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The immediate priority for the latter is to keep effective demand in the world economy sufficiently high even as households deleverage (cut spending in favour of saving) and many corporates defensively cut inventories, fixed investment and labour forces.

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Thus, the US government wants fiscal emergency packages everywhere to maintain global spending, consumption as much as investment, imports as much as exports.

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Others, with histories of painfully restoring their national finances to health after wide irresponsible detours, often ideologically induced, aren’t so keen. One example is Germany, but many smaller countries hold similar views.

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This is in part a free rider problem, with little and not so little guys wanting to do as little as possible, hoping to keep their finances healthy and limiting future burdens while the big guy does the heavy lifting and pays the potential long term price of impaired finances and competitiveness.

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There is a touch of righteousness here (the Americans created this problem, let them catch the falling knife), but it is more than this.

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For some it is ideological, not wanting to sacrifice one’s long term financial health for uncertain short-term gains. Yet it is precisely the Keynesian insight about all being dead in the long term that prescribes focusing on the short term if one wants to prevent enormous economic pain from being incurred for a very long time due to inadequate demand settling in and not easily being budged.

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These tiffs extend into academia but also along the political spectrum.

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In the US, the Republicans are the righteous defenders of the neo-classical faith, whose mantra is a simple one – stability is the central assumption, and any investment mistakes should be allowed to be washed out, so that the system can rise off its own bat, purged, lean and mean and roaring to go.

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But as Larry Summers puts it, “this notion that the economy is self-stabilising is usually right but it is wrong a few times a century. And this is one of those times ……… there is a need for extraordinary public action at those times”.

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The philosophical divide extends deeply into academia.

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Both neo-classical and New Keynesian macroeconomic frameworks depend on rational expectations, fed by the Great Moderation of post-WW2 decades in which there ultimately no longer proved to be space for uncertainty.

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Philosophically, information is freely fed into these models from the outside. In the neo-classical case it is the Walrasian Auctioneer and for New Keynesians it is the information generated by the model.

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Effectively this is the same thing, if subtly different.

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The bottom line in both approaches is that uncertainty cannot exist. It isn’t possible to encounter something as is currently entertaining the world daily.

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Both approaches advise that the financial and economic system will recover by itself under all circumstances.

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In contrast, government intervention is seen as always fatal, being castigated as a source of instability.

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Yet sometimes enormous shocks can develop, coming from the outside, so big that uncertainty becomes an overwhelming reality from which it is difficult recovering, as Summers put it so succinctly.

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It is at such moments that the only party not usually subject to uncertainty and its paralyzing fears is the state, it not being guided by commercial considerations. At which point the state can play saviour if it understands the situation and the contribution only it can offer when all have withdrawn to the sidelines, refusing to dance.

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Thus, the contrary view to both neo-classical and New Keynesian offerings is that reality isn’t mostly stable. The opposite is true. Real life per definition is unstable. If events reduce risk-taking and effective demand, these reactions may ultimately prove large enough such as to induce paralysis, both taking very long coming back under their own steam.

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A global majority today favours being proactive and supportive rather than standing back. Still, it is an important divide, and may prevent as much of a global effort, and soon enough, that would limit the transition cost of getting fully back on stream.

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This feeds reputation risk for legions of forecasters reading the tealeaves and advising their clients.

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Will the world descent into depression and deflationary feedback loops as all fall down and little can be done to prevent it happening, taking years if not decades to fully come back from such disaster?

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Then there are those who are simply skeptical about financial repair efforts (it takes oodles of time sorting out banks), about government actions (getting fiscal stimulus agreed and enacted), about what Anglo-Saxon central banks think they are doing (inflating their balance sheets and potentially laying the foundation for the next great financial disruption via currencies and inflation), and what the huge government debt enlargement will do to private capital markets.

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All of this takes time, a lot is experimental, some of it won’t work, and confidence will take time to be restored.

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Ergo, don’t hold your breath, as this will take more than a few quarters to get right (more likely years, if not decades).

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Finally, there is the simple quarterly forecast modeling inventory drawdowns (always coming to an end), fiscal injections (always showing up, however weak), credit system repair and resumption of bank lending. And, most crucially, the gradual return of confidence (or rather the slow subsidence of fear).

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After maximum car replacement delay, big fixed investment cuts, inventory drawdowns and labour force shedding, the economy stabilizes and then starts to respond favourably to lower energy prices, slashed interest rates, huge fiscal injections and major currency changes. And critically there can be observed a change in sentiment as bank repair at some point is seen to be working, led joyfully by equity markets rising. Fear (paralysis) starts to subside.

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After writing off a few quarters, admittedly more of them and much deeper than usual, it is time to get back on track. In this fashion, the US entered recession in late 2007, fell of a cliff in 4Q2008, will explore even lower levels of deprivation in 1H2009, and should be coming up for air in 2H2009, positive growth resuming in 2010.

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This is of course a rolling forecast, with every passing month, and quarter, creating new opportunity to extend the forecast yet more as reality is turning out to be a good deal more horrendous than ever imagined.

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But then what did you expect?

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“They” blew up the world, meaning the banking system and with it a few other things, such as housing, insurance, equity markets, a few pension plans and companies, and much more besides.

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It takes time, effort, ingenuity and political will to come back from that. And the world is doing so, though not quite unified about how to do so in the fastest possible time with the least sacrifice.

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And so we are still exploring the full extent of this shock and the loss it will impose on us before normality is restored and life can resume its reach for the stars.

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As to any cyclical upturn commencing, it could still be before this Christmas, with President Obama having something real to promise this coming Thanksgiving, besides traditionally reprieving one lucky token turkey.

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And so we watch Bernanke, King and Trichet with morbid fascination, and with deep skepticism follow Geithner, Darling and a few others, with the orchestra of politicians (Obama, Merkel, Brown, Sarky and a supporting G20 cast of thousands) doing the directing.

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Would it have been different under Hillary? No.

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McCain? Definitely.

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Count your blessings, this coming X-mas. Only 275 more sleepies to go.-? -?-?-?-?

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Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics

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Ferrier International keeping you informed.

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interest rate cuts ahead

FERRIER International sharing the good news. We thank Cees Bruggemans, Chief Economist of FNB for this positive article and outlook for 2009.

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Interest rate cuts ahead

By Cees Bruggemans, Chief Economist FNB
03-?November 2008

Events have marched on to a point where the first of a series of SARB rate cuts are coming into view, timing as always the prerogative of the SARB.

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But do paint in a very high probability for December 2008 and a near certainty for February 2009 for the first cut.

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In contrast, the consensus keeps looking well into 2009 for that first rate cut. I have maintained for some time that events may be moving much too fast for that. Expect rate cutting sooner rather than later.

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And that is with impressive shock absorbers already fully extended. This refers to oil at $60 rather than $150. Also, the fiscal stance becoming supportive by the equivalent of 2% of GDP this year and probably again next year. The Rand’s 40% depreciation so far this year compared to 2007 average (and about 30% depreciation on trade-weighted). And the decline in real interest rates (however calculated), as rising inflation and inflation expectations this year outpaced rate increases.

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So in order to suggest nominal interest rate cuts sooner rather than later, one apparently believes the economy’s decline is worse than what these impressive shock absorbers can handle. Or the inflation rate is about to collapse impressively, in the process boosting the real interest rate to Kingdom come at the very moment that the economy finds itself in the middle of an old-fashioned recession.

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Or more likely one believes both these propositions.

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Let’s test them both before moving the focus to the SARB.

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Could the economy be weaker than thought? Easily so, as economic data and perceptions lag rather badly coming out of a high-performance growth era accompanied by even higher future expectations and dire political need for good news and little interest in bad news.

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But the shock absorbers may not all be what they are cracked up to be at first blush.

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Take oil. Nice, to see it collapse from $150 to $60. But unfortunately our Dollar export commodity prices have fallen even further, starting with platinum, from $2250 to $800.

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That takes care of the Dollar oil windfall. Worse, we produce 40% of our own liquid fuel requirements. That boosted Rand incomes when the oil price was rising, but the oil price fall will be contracting Rand income at our oil producers. That’s growth-suppressive.

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The Rand decline of 40% since 2007 is a great income booster, until one allows for the Dollar export commodity declines, but also declines in export volumes once global recession is fully discounted.

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Exporter Rand incomes may have been partly shielded by Rand decline, but not fully so. Households and businesses will have some benefit from the falling oil price, but most of the benefit is eroded by the depreciated Rand.

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So yes, exporters are not falling off a cliff, but our households are not getting much of an oil price windfall either.

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Meanwhile, the nominal interest rate increases of the past two years are steadily grinding away at household consumption growth, which by this time is probably already negative. Private fixed investment also suffers in part, in addition to the effect of constrained electricity supply. There is evidence of inventories being reduced. Real household income may be under pressure from real wage adjustments, employment and flexible income sources (bonuses, commissions and overtime especially).

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Thus inflation may have outpaced nominal interest rate increases and may thereby have reduced real interest rates this year, but its beneficial effect is yet to start shining through in growth support.

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Indeed, the 40% Rand decline, most of it occurring these past two months, has greatly increased interest rate anxiety, with greater fear of either further nominal rate increases, or delays in rate cuts, prolonging the period of severe household stress, in turn inducing yet greater willingness to postpone durable goods replacement and intensify belt tightening.

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Has enough therefore been done to moderate the cyclical growth interruption? Probably not, indeed increasingly not, as external events keep piling up the pressure.

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If monetary policy has so far chosen to increase nominal rates and keep them elevated, this is very much a reflection of the sharp increase in inflation and inflation expectations these past two years, and the risks of keeping them elevated through next year.

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But that was the musical sheet of the past twelve months. Is it being overtaken by events? I think so.

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CPIX inflation peaked at 13.6% in August, and undershot marginally at 13% in September. Coming months could see more undershooting if oil keeps heading lower, food prices have passed their peak, the Rand proves more resilient than expected and the pass-through from the weaker Rand is less than postulated.

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It is true that OPEC has announced output cuts of 1.5mbd, with more probably to come. But high-cost marginal producers will probably cheat, Saudi will want to keep the Americans friendly (and not forgetting its own long-term interest in optimising oil wealth), and US domestic petrol consumption is now apparently 9% down (but for how long?). Anyway, futures markets are betting on $50 oil next year (though these bets have been wrong before).

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But even if one doesn’t get too bullish on oil (the SARB certainly won’t), one has reason for quiet optimism regarding food, Rand, Rand pass-through, rebasing and reweighting, though rentals could be a bedbug.

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Administered prices excluding oil are 15% of the CPI basket and apparently remain a great pain to the SARB. Government is simply not keeping to the prescribed inflation target of 3%-6%, understandably so for electricity (paying an enormous price for past incompetence), but less excusable elsewhere, especially in local government.

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Despite these obstructionist elements in the inflation basket, recorded inflation could fall very sharply in coming months through mid-2009. Do expect a falloff in inflation expectations to follow as a matter of course. That would take care of many second-round effects, as would the weakening economy and increasing resource slack (though some unions and skills shortages will prove immune, as may some politicians).

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So our real interest rates are now on a steeply rising slope, at the very moment that global interest rates are collapsing in union, with the exception of those few small economies with unsound policy frameworks under interim IMF tutelage.

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The US is on its way to 0.75% (from 1% currently and 5.25% a year ago). Europe is on its way to 2% from 4.25% two weeks ago. Britain is on its way to 2%. Australasia is aggressively cutting rates. India may be aggressively cutting rates after so far moving twice by 1% and 0.5%.

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Things are hotting up out there. The differential with our rates is going through the roof shortly. Do we really need that? It will only depress our inflation even faster, going by the historical record.

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Globally, the financial crisis is finishing off (with the most difficult trillion disorderly written off and another more orderly trillion or so still to go).

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The Fed, ECB, BoJ and IMF have started extending support to the EM universe where liquidity is needed, in the process soothing market anxieties (probably all that is really necessary).

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What is increasingly coming into focus is deep global recession through next year, requiring extensive interest rate easing (where rates are not already at 0.3% as in Japan or 0.75% as in the US shortly), and fiscal support (impressively so in the US but not limited thereto).

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Finance Minister Manuel is doing his bit (or rather the weakening economy and higher wage and infrastructure costs are doing it for him). Now it is the turn of the SARB to indicate where it feels it can contribute.

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Perhaps on this score a useful aside is in order to better understand the forces at work in monetary policy.

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In modern monetary policy there is a battle royal going on between those preferring pure credibility seeking (so-called inflation nutters focusing on inflation pretty much to the exclusion of all else) and those emphasizing flexibility (taking into account to a greater or lesser degree output considerations as well, smoothing policy responses over time rather than hammering things).

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Indeed, when expressed in an equation, the old Taylor rule pops up. One component of this reaction function examines actual inflation and where you want it to be (target), thus defining an inflation gap, while the other component examines the output gap, whether or not output is overshooting or undershooting.

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The inflation nutter simply focuses exclusively on the perceived inflation gap, arguing that if you can get that right everything else will follow.

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The flexible approach, on the other hand, prefers to split the process of containing inflation into a direct and indirect component. It directly wants to address the inflation gap, and indirectly influence inflation by addressing the output gap, but in this manner also preventing undue output variability (and its potentially unfriendly political fallout).

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The flexible approach comes across as perhaps more sophisticated, wanting to reconcile two potentially opposing gaps (inflation and output) simultaneously, optimizing the general economic condition over time while centrally addressing inflation.

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But it is more complex than that.

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Anyone starting out in life has no credibility. Acting strongly for a while in the dominant alpha tradition establishes one’s credentials. Once achieved, there is less need to keep on proving manhood.

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Like Teddy Roosevelt a century ago, you can then move quietly while carrying a big stick. This condition, once achieved, allows one to become more subtle without being penalized for loss of credibility, being less imposing on the economy yet achieving more.

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It would seem our SARB has evolved nicely in this respect, with or without help from political considerations. Our inflation targeting policy is well established, our markets respond well, and even the less flexible parts of our economy respond, if with a lag.

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This has already for some time now allowed more emphasis on policy flexibility rather than credibility. It was explained like this in old Monetary Policy Reviews a few years back (though possibly ignored by too many even today). There is no harm in emphasizing it again today. Especially so as this policy characteristic has been on show the whole year, with interest rates not increased as fast as inflation, the SARB apparently being prepared to smooth the real rate effects over time.

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But this renewed emphasis on monetary policy flexibility could not come at a more appropriate time, with the economy steadily weakening, high inflation now in remission, and external risks greatly diminished (oil), going there (food) or getting there (global financial crisis and EM exposure).

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With the inflation gap about to start closing rapidly (let’s not argue too strenuously as to when we will re-enter the target as nobody really knows, but it may be sooner rather than later), and external risks diminishing daily (though keep a sense of proportion) even as the output gap is steadily deteriorating, it doesn’t require rocket science to see where this may be leading. Soon, too, by all appearances.

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Expect a series of interest rate cuts, starting soon. Along with a more accommodative fiscal stance, this may assist in keeping the looming recession next year mild, meaning shallow and short, despite an increasingly intimidating global recessionary backdrop.

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Politically, that would be extremely good timing, too.-? -?-?-?-?-?-?-?-?-?-?-?

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Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics

FERRIER International keeping you informed thanks to Cess Bruggemans of First National Bank.The tide is turning and we trust that wise investors will see the light.

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