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  1. #1
    Join Date
    Feb 2005

    Policies (and Money) Tighten in '06

    Risks Ahead as Policies (and Money) Tighten in '06

    FRANKFURT, Jan. 2 - This is the year that the world's major economies will have learn to live without easy money.

    The Federal Reserve has already significantly tightened monetary policy in the United States. The European Central Bank raised interest rates last month for the first time since 2000, and will probably lift them again. And after nearly five years of zero percent interest rates, the Bank of Japan is expected to embark on a cautious tightening of policy - not necessarily by lifting rates, but by cutting back on its purchase of government bonds from Japanese banks, which pumps yen into the market.

    These moves will have far-reaching consequences for the world economy, as well as for financial markets. Economic activity in the United States, Europe and Asia has been lubricated by loose credit since 2001, when the collapse of technology stocks led to an easing of monetary policy.

    Removing this stimulus without choking off growth in Europe and Japan or taking the wind out of the housing market in the United States will be an exceedingly delicate, if not risky, task.

    "This is a high-wire act," said Thomas Mayer, the chief European economist at Deutsche Bank in London. "The global economy has been propped up by huge liquidity. The question is, How do you take this liquidity out of the economy without the whole thing crashing down?"

    Very carefully, central bankers in Washington, Frankfurt or Tokyo might well answer.

    None of the three banks is acting aggressively, and two of them, the European Central Bank and the Bank of Japan, seem prepared to rethink their plans if economic conditions suddenly deteriorate. While the Federal Reserve has left itself room for further rate increases, it is believed to be nearing the end of this cycle after raising the rate to 4.25 percent in 13 consecutive quarter-point increases.

    The good news, analysts say, is that the world has a fair amount of momentum as it heads into 2006. Propelled by a fast-growing Asia and a still-vibrant United States, the global economy could expand 4.5 percent this year, according to Deutsche Bank. That is roughly on par with 2005.

    While housing prices in the United States may have peaked, the economy remains vigorous, and consumer spending is likely to get a fillip from the easing of oil prices. Deutsche Bank forecasts that the American economy will expand 3.9 percent in 2006, a shade more than last year. Other economists expect less robust growth, on the order of around 3.3 percent, compared with this year's expected 3.7 percent.

    Growth is also likely to accelerate in Asia, thanks to a reinvigorated Japan and the continuing boom in China. The Chinese economy will expand nearly 9 percent in 2006, only slightly less than last year, according to a forecast by the Asian Development Bank.

    Even Europe, which fell short of expectations last year, may perk up in 2006, thanks to continued strong demand for its exports - from China, as well as from traditional markets like the United States - and signs that Germany's long-dormant consumers are stirring.

    There are caveats to this upbeat scenario. A sharp decline in real estate prices in the United States, rather than the expected gradual softening, would crimp consumer spending. That would hurt both Europe and China, which ships 40 percent of its exports to the ravenous American market.

    A slowdown in China's export-led economy, either because of internal political pressure or external resistance, would also reverberate globally. China's relentless rise as a low-cost manufacturer has helped the global economy in a number of ways, not least by driving down inflation.

    "For the last three years, we've had a two-engine world: the Chinese producer and the American consumer," said Stephen S. Roach, the chief economist at Morgan Stanley. "Both engines are going to slow down. The debate will be whether this two-engine global 747 is in danger of stalling."

    Sometimes regarded as an economic Cassandra, Mr. Roach is not actually predicting such a calamity. But he says that there are risks. If China's exports continue to boom, China will face rising pressure from the United States to further revalue its currency, the yuan - a move that could start to reorient its economy from exports to its vast domestic market.

    "Everybody still embraces China as a perma-growth story," Mr. Roach said. "But that will be challenged in 2006."

    A renewed weakness in the dollar, which Mr. Roach expects this year, would put pressure on American consumers because it would make imports more costly. That, in turn, could threaten the sky-high housing market, without which, he said, "the American consumer is toast."

    In any case, the lopsided trade relationship between China and the United States will likely re-emerge as the decisive factor in the value of the dollar. The dollar's resilience proved to be one of the major surprises of last year. It declined sharply against the euro, yen and other currencies in 2004, and Mr. Roach and others expected it to fall further in 2005.

    The United States, after all, is running a quarterly current-account deficit - the broadest measure of its balance of trade - of nearly $200 billion, which most economists view as unsustainable.

    Instead, the dollar staged a rebound, driven in part by the widening gap in interest rates between the United States and Europe and Japan. The euro was also weaker because of Europe's anemic economic performance, the deadlocked German elections and the rejection of the European Union's proposed constitution by voters in France and the Netherlands.

    Now, with Europe and Japan reviving and with the Federal Reserve perceived as nearing the end of its tightening cycle, analysts predict that the dollar will resume its downward course against the euro and the yen. They note, too, that the current-account deficit is coming back into focus.

    "Investors will once again take this risk into account," said Michael Schubert, a currency analyst with Commerzbank. "The only thing we know about the current-account deficit is that it can't go on forever."

    Mr. Schubert forecasts that the dollar will trade at $1.28 versus the euro by the end of this year; it is currently $1.185. He said the yen's value would hinge on the actions of the Bank of Japan, while the Chinese would modestly revalue the yuan, having done so once last summer.

    A weaker dollar could help American stocks, Mr. Mayer said, because it would make American exporters more competitive. But with the uncertain prospects for consumer spending, it might be difficult for American markets to match their buoyant performance of recent years.

    Conversely, a rising euro would not be welcome in Europe, which relies heavily on exports. Morgan Stanley expects European stock markets, after a remarkable rally in 2005, to stagnate this year, especially with corporate profits already high and interest rates starting to climb.

    Repeating the performance of 2005 will be especially difficult in Germany. The DAX stock index, which includes big names like DaimlerChrysler, Volkswagen and Siemens, rose more than 30 percent - a sprightly pace utterly at odds with the country's sluggish economy.

    Despite the muscular euro, Germany demonstrated in 2005 that it could maintain its title as the world's top exporter of manufactured goods. One factor was China's demand for heavy machinery and other products. But German companies, analysts said, also improved their competitiveness generally by cutting costs and keeping a lid on wage increases.

    "The success of Germany's export sector has been remarkable, and I think it's quite likely to continue," said Michael Heise, the chief economist at Dresdner Bank and Allianz in Frankfurt.

    The question is whether stricter monetary policy will strangle Europe. Despite a few rays of hope, consumer demand in Germany remains weak. Italy has been skirting recession and France is saddled with double-digit unemployment, which some blame for the recent surge of urban unrest there.

    European politicians have vigorously protested the central bank's recent shift in policy, saying that the continent's economies are still too fragile. They say that the bank has also overestimated the threat of inflation, particularly since oil prices have moderated after surging for much of 2005.


  2. #2
    Join Date
    Feb 2005

    Re: Policies (and Money) Tighten in '06

    In fact, tighter monetary policy on three continents could help keep the price of crude oil in check this year.

    "Part of the run-up in oil prices was a reflection that there was a lot of monetary stimulus in the market," Mr. Mayer said. "Taking some of that out of the market could take the air out of oil prices."

    Deutsche Bank forecasts that oil prices will ease after the winter, though the average price per barrel may end up the same this year as last. By the end of 2006, it projects a reduction in prices as demand moderates and OPEC members increase their production capacity.

    With the retirement of Alan Greenspan this month - and the arrival of Ben S. Bernanke as the new Fed chairman - and with the major central banks moving in tandem to tighten credit, 2006 promises to be an eventful year for those who watch these institutions.

    "The Greenspan era has coincided with a period when the global economy has made the job of a central banker easier," said Kenneth S. Rogoff, a professor of economics and public policy at Harvard.

    The curse of high inflation has receded, he said, because the competition from low-cost producers like China has driven down the prices of so many goods. That is why the economic health of China - just like that of the United States - is a matter of concern to everybody.

    "China has made everything run better," Mr. Rogoff said. "If it were to collapse, Ben Bernanke might be in the uncomfortable position of having to set interest rates much higher than he expected."


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