The world according to Frederic Mishkin

 

Writing from Anandale, New York, I was listening to Federal Reserve governor Fredrick Mishkin, one of the more impressive US economists, who last year was appointed to be a governor of the Federal Reserve board. His speech at the Hyman Minski conference on the state of the US and the international economy at the Levy Institute at Bard College gave us one piece of new information (or rather it confirmed something we suspected all along). Mishkin is really a policy dove whose comfort zone for inflation is not 1-2%, the range usually mention by Fed governors, but 2%.

 

Less surprisingly, he toes the Fed's optimistic line on economic growth. Bernanke and Mishkin both need and seek credibility in the financial market, and they both will try to uphold the optimistic scenario - together with the current interests rate - for as long as it is possible. If something happens, they will act, but probably late and not by much. Come to think of it, the new Fed is very much like the old ECB.

 

Mishkin's analysis of US inflation is relatively benign also, and he believes that core inflation, the measure which the Fed targets, will come down to 2%, his own comfort number, as the rental component in the index will show a slower growth in the future. He is equal upbeat - though naturally less certain - about inflationary expectations.

 

Unfortunately, few of the economists present at the conference, which the exception of a few Wall Street types, believe in the Mishkin/Bernanke scenario. The talk among US economists is very much on the lines of an economic downturn, and/or a financial meltdown, beginning at some stage this year. There is significant concern about the housing market, and its inter-linkages with other parts of the economy. In my own speech at the conference, which follows the arguments presented on this website, (in my FT column last week, or our ECB Watch last week), I focused on the link between the US and the world economies, and made the point that there are several potent transmission mechanisms of a US economic and financial shock to the rest of the world (equity markets, property, credit markets, the exchange rate).

 

Robert Parenteau, an economist at RCM, a pension fund, made a powerful and impressive argument in favour of strong inter-linkages between the housing sector and others parts of the domestic US economy - in particular on consumption and investment. It is very difficult to imagine that a housing downturn of the scale the US is currently experiencing (one of the greatest ever recorded) would have only a benign effect on economic growth. In other words, there is little prospect of decoupling even inside the US, let alone outside the US. The US is experiencing a downturn, no doubt, even though some of the indicators, such as leading indicators, do not yet suggest that this downturn is imminent. Having spoken to the economists present at the conference, a mix of academics and financial markets economists, I would put the consensus in favour of a negative growth rate as of 2008 at about 50%. The mood was more negative than I expected.

 

What spooks most of the observers - and possibly Mishkin as well since he refused to get drawn in on the subject - is the implication of the credit markets for the rest of the economy. The US credit markets (see also my forthcoming FT column on this subject) have had a pathological impact on the financial system, leading to a large and persistent mispricing of risk. The adjustment in this sub-segment of the market alone will be a serious economic shock in its own right.

 

There is very little the Europeans can do about any of this. The best policy advice would be to be cautious about monetary and fiscal policy. This means, concretely, that this is a very good time for deficit cutting (right now, not 2010 as the finance ministers are proposing), but also a good time for some moderation in monetary policy. I personally would leave interest rates unchanged at the current level of 3.75%. I am sure the ECB will raise to 4% in June (as everybody else believes as well), but I am also becoming increasingly convinced that we reached the end of the tightening cycle. There are storm clouds forming in the US. Official America is still in denial over this, but there are good reasons why this is so. Watch out!

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