Monday, 17 December 2007

Roubini on Deflation

In an interesting post on why the US Federal Reserve should cut interest rates aggressively despite not being able to prevent a recession, Nouriel Roubini touched on the topic of deflation. I put forward yesterday the case that deflationary pressures will overwhelm inflationary pressures in 2008. Below is Roubini's take, click on the title link below for the full article. From RGE monitor:

Why monetary policy easing is warranted even in the current insolvency crisis

Third issue: would monetary policy easing cause a much higher inflation rate and undermine the anti-inflation policy credibility of the central banks? After all inflation rates are now rising around the world thanks to high and rising oil, energy, food and oher commodity prices. My answer to the question above is no as a US hard landing followed by a global slowdown will seriously reduce those inflationary force and would – like in 2001-2003 – rather induce serious deflationary risks.

Inflationary pressures may be elevated now but they will fizzle away in short order once the US hard landing is in full swing. Thus, the central banks current concerns with a rise in inflation are misplaced as a US recession will lead to global disinflation (and concerns about deflation as in 2002-2003). There are at least four reasons why these global inflationary forces will abate once this US hard landing occurs:

a) a fall in US aggregate demand relative to supply;

b) a slack in labor market conditions and slowdown in wage growth as the unemployment rates sharply increases;

c) a fall in global aggregate demand as the glut of output from overinvestment in China and some other emerging market economie will face a fall in global demand as the world re-couples with the US hard landing;

d) a sharp fall in oil, energy, food and other commodities prices as a global slowdown emerges.

We are thus set for the repeat of the 2000-2003 cycle when the Fed and other central banks underestimated the downside risks to growth and overestimated the upward risks to inflation and ended up having to aggressively cut rates to deal with the fall in economic activity and the deflation risks that such a US and global recession triggered.