Greenspan's moves

The global reflation trade is unravelling. Last Tuesday, the US Federal Reserve raised its fed funds rate by the customary 25 basis points, but it changed the wording of its accompanying statement to imply that inflationary pressures have increased.

That was enough to send shock waves across world markets. US stocks and bonds fell, and yields spiked. The dollar strengthened on the expectation that higher yields in the US would induce funds to move back to the US. Emerging market stocks, bonds, and currencies weakened.

The carry trade in emerging market assets""borrowing cheaply in the US to buy non-dollar assets""was hit. Emerging market equity funds had their worst week of net outflows since last May.

Emerging market bond funds also saw outflows. Commodities and crude prices, denominated in US dollars, fell.

There are several reasons for concern. First, US producer prices have risen more than before, as have consumer prices, with a large rise in "core" inflation, which excludes food and energy prices.

The markets have interpreted that to mean the Fed is poised to increase the pace of monetary tightening, in spite of its continued assertion that the pace "is likely to be measured".

Of course, this is not the first time that such scares have occurred. The last one happened in January, when the minutes of a Fed meeting gave the impression that inflation was raising its head in the US.

Earlier, the carnage in emerging markets last May was the direct result of the US central bank raising the fed funds rate, and worries that emerging markets would see a re-run of 1994.

At the back of the nervousness is the unprecedented US current account deficit, and the need to finance it with inflows of more than $2 billion a day. That deficit has been fuelled by US consumption on the back of large increases in consumer and mortgage debt.

Asian nations, on the other hand, have kept their factories humming by exporting to America and investing their dollars back into US securities, keeping US interest rates low and the US consumer happy.

The Federal Reserve has been trying curtail the deficit through a weaker dollar. But with China pegging its currency to the dollar, this strategy is doomed to failure. And with Chinese prices being so much lower than in the US, it is doubtful if the deficit would adjust even if China were to revalue the renminbi.

Under the circumstances, a gradual cooling of the US economy, through higher interest rates, is probably the best option. The worry is that this could impact the highly leveraged US consumer adversely.

Alan Greenspan will therefore have to steer a careful course in trying to ensure a soft landing for the economy. Even the gradual reducing of global liquidity that this strategy entails will mean lower asset prices.