Last week I could do no wrong. This week I’m a bum. A huge reversal in stock and bond markets has rekindled the hopes and dreams of economic revival. Those great forward-looking discounting mechanisms that drive financial markets must know something, claim the optimists on the economy. What have I missed this time?

While markets can often turn on a dime, a $32-trillion world economy doesn’t. That’s especially true of the US, where the backward-looking data flow, if anything, has been biased to the downside over the past week. Retail sales sagged appreciably in September, consumer confidence was down sharply in early October, new claims for unemployment insurance benefits went back up after a statistically distorted plunge, and industrial production recorded its second monthly decline in a row in September. Housing starts did surge, but that did not outweigh the persistently tough news elsewhere in the economy. On the basis of the latest statistics, we see little reason to change our assessment of an anemic 0.9% annualized growth rate in current-quarter real GDP.

Nor does the broader world economy suddenly look to be in any better shape. Signs out of Euroland are continuing to worsen. The latest production data remain skewed toward weakness. Germany looks especially vulnerable, with an early read on business expectations taking a sharp tumble in October. And there’s no help on the way from an intransigent ECB. At the same time, the Japan story is far from uplifting, with the latest data revealing further weakness in machine tool orders, another decline in Tokyo department store sales, and persistent softness on the production side of the equation. Only in China did the data flow over the past week signal any vigor, with accelerating trends in industrial output, retail sales, exports, and GDP. Notwithstanding the "China factor," it’s hard to point to any signs of incipient revival in the non-US portion of the world economy that might provide fundamental justification for the recent surge in global stock markets.

But the screens don’t lie, and world equity markets have certainly exploded to the upside in recent days. America, of course, has led the way, with the S&P 500 Composite Index now up an astonishing 13% from its October 9 lows. Even so, this index remains some 18% below its year-earlier level, fully 42% below its March 2000 high, and still back at levels prevailing in mid-1997. For index-based investors -- we should all be so lucky -- five years of stagnant current-dollar returns translate into a cumulative loss of about 12% in real terms. Relative to historical returns of 7% per annum, the opportunity cost of this wealth destruction is all the more severe. In other words, notwithstanding the powerful moves in five of the past six trading days, wealth-dependent American consumers still remain very much in the hole.

The recent rout in the Treasury market needs to be viewed in a comparable light. With the yield on the 10-year surging by some 70 bp since October 9, the bond market has gone through one of its worst firestorms on record. Yet in the general scheme of things, today’s "elevated" interest rates hardly pose a threat to the real economy. The best way to see that is in a "real" interest rate framework -- the inflation-adjusted rates that drive real economic activity. On this basis, real yields on the 10-year Treasury as measured in the TIPS market have increased by some 40 bp from last week’s lows "all the way" back to 2.6%. But even so, these yields remain below the 3.0% level of a year ago and well off the 4.25% highs of early 2000. In short, as wrenching as the recent backup in yields feels, it has yet to result in restrictive enough interest rates that would impede economic activity.

The impact of these gyrations cannot be minimized on one count, however. It heightens an already elevated uncertainty factor -- hardly a plus for the real economy. Dick Berner has said it for a long time: Uncertainty is the enemy of growth, and I couldn’t agree more. Most equity strategists, including ours, believe that the October 9 lows were the real thing -- that this wrenching bear market in stocks has finally run its course. That’s certainly possible, but I well remember similar claims being made about the lows of September 21, 2001 and again regarding the lows of July 23, 2002. Why should last week’s low be any different -- especially if the economic recovery remains anemic at best? To the extent this debate is alive and well, there’s nothing all that comforting about the violence of the recent reversal in the markets. It speaks more to the fragility of any market adjustments than it does to sustainability. In this era of financial-market-driven economies, such disbelief and uncertainty can hardly be viewed as a plus.

Nor is market volatility the only source of uncertainty overhanging the economic outlook. Geopolitical concerns have also intensified, with the apparent terrorist attack in Bali only heightening the angst over a likely war in Iraq. As I speak with investors about these issues, an interesting and important dichotomy has emerged -- especially with respect to Iraq. Americans are focusing mainly on the likely success of the looming battle, whereas non-Americans are focusing more on the perils of a post-Saddam Iraq. The American point of view concludes that sharply lower oil prices must be in the offing as soon as the battle begins, an outcome that would be the functional equivalent of a big tax cut for the world economy. The non-American point of view believes that a lasting US or Anglo-Saxon presence in administering a post-Saddam Iraq would serve a lightning rod for an Islamic backlash and intensified terrorist activities. Such instability could easily spill over into the Israel-Palestine dispute. The oil price would undoubtedly remain sharply elevated in that scenario, a surefire recipe for renewed global recession. To the extent that it’s virtually impossible to know with certainty which of these bipolar outcomes will come to pass, the geopolitical uncertainty factor will undoubtedly remain high in the months ahead. That’s hardly a plus for global growth.

The confluence of financial market gyrations and heightened geopolitical angst does little to neutralize the uncertainty factor that remains an impediment to global recovery. Add in a lack of pricing leverage and still very depressed earnings, and it is difficult to envision businesses stepping up with capital spending and hiring that might otherwise fuel a more sustainable and vigorous cyclical recovery. The same would be true of consumers -- the anxiety factor is antithetical to job and income security and hardly conducive to debt-intensive discretionary buying. Yes, a lot has changed in the markets in the past week. But nothing has really changed on the economic front. The French put it best: "Plus ca change, plus c'est la meme chose."

The risk of US deflation is low -- no higher than 15% over the next 12 months, in my view.  Among the reasons: Inflation expectations show little sign of tilting in that direction.  In the early October University of Michigan canvass of consumers, the median expectation for inflation one year ahead actually ticked up to 2.7% from 2.5%, perhaps reflecting concerns about rising energy prices.  In addition, companies are shedding capacity, as the meager upturn in capital spending under way has been too feeble to arrest the stalling in capacity growth.  And monetary policy still seems poised to ease further to insure that any deflation risks won't morph into reality, although Fed officials continue to express patience with the bumpy and irregular pace of the recovery, and Fed Governor Bernanke this week handicapped the risk of US deflation as "remote."

But deflation risks have risen slightly as a weak global economy, a still-strong dollar, and below-trend US growth persist (see "Deflation Risks -- Still Low but Rising," Global Economic Forum, October 1, 2002).  And my colleagues Steve Roach and Andy Xie correctly point out that the global economic setting is highly disinflationary.  They note that globalization and an increasingly open US economy combine to expose the US economy perhaps more than ever before to the winds of deflation from abroad.  And those winds, especially from China, are getting stronger.  High-cost industrial economies relocate production facilities to China and export home at much lower prices.  With its huge surplus of labor, China's industrial workshop in the Pearl River delta likely will grow in influence.  Andy and I agree that America can avoid deflation if we can shift resources from glutted sectors to those where returns are higher.  Believe me, it's happening.

Yet Steve fears that the resulting declines in goods prices are only the first step, and that global competition in services augurs deflation ahead (see "Services --The Next Leg of Deflation," Global Economic Forum, October 7, 2002).  I take his point that the simplistic model of the past, in which services were shielded from competitive forces, is an anachronism.  Moreover, having done some of the first work on international influences on US inflation as a young economist at the Fed, I certainly appreciate the scope for deflation abroad to influence US inflation, whether in goods or services (see Richard Berner, Peter Clark, Jared Enzler and Barbara Lowrey, "International Sources of US Inflation," US Congress, 1973).  And there's no mistaking the classic disinflationary forces at work in the aftermath of US recession, which affect the pace of services price hikes as well as those in goods.  But I believe that all those forces are disinflationary, not deflationary.  And in my view, there's little sign of lower underlying services inflation, let alone deflation.

In fact, services inflation has recently slowed, but energy price swings account for the entire decline.  From the fourth quarter of 2000, near the business cycle peak, services inflation measured by the GDP deflator for services output declined from 3% to 2.3%.  But the winter of 2000-01 was the second coldest on record, and heating oil, electricity and natural gas prices had skyrocketed in response, temporarily pushing up overall services price change.  By the first quarter of 2001, the price index for electricity and gas was up 17.9% from a year earlier.  By the second quarter of this year, however, that price index had plunged by 7.6% from a year ago, bringing "headline" services inflation down.  In contrast, calculated measures of services inflation excluding energy have been rock-steady -- for services GDP, at 2.7%, and for consumer services outlays, at 2.9%.  I'm wary of such "core" measures; after all, purging inflation measures of enough of the things that go up or down will always make them look better or worse.  But unprecedented swings in energy prices call for appropriate adjustment.

This recent episode was unique in the recent annals of energy shocks.  While energy price swings have triggered higher and lower overall inflation before, the 2000-02 period marked the first time that energy price swings were large enough to dominate the services grouping.  The massive energy price hikes of 1973-75 and 1979-80 mainly affected goods inflation, at least directly.  To be sure, those oil and energy shocks also raised inflation in services.  Higher energy prices directly boosted electricity and gas quotes.  And they raised services inflation indirectly through hikes in the prices of energy-intensive services such as air transportation.  Most important, they fueled already-rising inflation expectations.  In contrast, energy supply shocks in today's context are likely to be disinflationary, because they threaten global growth.  Ironically, they may thus keep alive deflation fears.

More Focus on Equity Markets 

As usual, the Editorial of the ECB's Monthly Bulletin repeats the main message from last week's press conference: The ECB sees the risks to price stability as balanced at present, and a rate cut thus does not appear to be imminent as yet.  The main difference between last week's statement and the Editorial is that the latter contains a paragraph detailing more explicitly the downside risks to the economic outlook emanating from the sharp drop in stock prices, which affect the economy via wealth effects and cost-of-capital effects.  This passage is very similar to the one in Wim Duisenberg's testimony before of European Parliament on October 8 and thus doesn't represent new thinking at the ECB.  It confirms, however, that the ECB is watching stock market developments very closely and that a reversal of the recent sharp equity rally and a move toward new lows could well pave the way for a rate cut this side of Christmas.

Compared to September, Subtle Shift Toward Less Hawkish Stance

While the ECB does not seem to be in a hurry to ease policy, a comparison of the October Editorial (and last week's press conference statement) with their September counterparts shows a subtle shift toward a less hawkish stance.  First, the addition that the risks to price stability are seen as balanced "at present" suggests that this can change at any time.  Second, while the ECB saw "less risk that excess liquidity would will translate into inflationary pressure" in September, the Council now "does not see the risk of this translating into inflationary pressure".  Third, but not least, while the September statement and Editorial said that the factor representing upside risks to price stability needed to be monitored closely, in October the ECB states that "all factors that could influence the balance of risks to price stability" (i.e., those pointing to upside and those pointing to downside risks) need close monitoring.

Perceived versus Actual and Expected Inflation 

In a special focus piece, this Bulletin again looks at the divergence between inflation as it is perceived by consumers (high, but seemingly peaking out in the most recent month) and actual inflation (on a downtrend after the upward surprise earlier this year).  Moreover, an analysis of expected inflation (according to consumer surveys) shows that consumers' inflation expectations have fallen throughout this year, more in line with actual inflation than with perceived inflation.  In fact, expected inflation according to the surveys is now as low as it was in early 1999, when actual inflation rates were much lower than they are now.  The ECB concludes that the gap between perceived and expected inflation indicates that consumers see this year's price shock as temporary.  At the margin, this should make the ECB more confident that the price shock will not fuel wages and inflation looking forward.

House Price Inflation Eased, but Still High 

In another special focus, this Bulletin updates and extends a rough measure of house price inflation in the euro area introduced in an earlier Bulletin.  Based on national data from varying sources, average house price inflation eased slightly further in 2002 to around 6%.  Since 1999, house prices have increase by between 5% and 7% per year in nominal terms, with a peak in 2000.

Strong Message on Fiscal Policy 

Using somewhat stronger language than usual (as is already evident in the press conference), the Bulletin calls for "decisive action" by the high-deficit countries to establish fiscal adjustment paths entailing significant reductions in the structural deficit each year.  Also, the ECB demands "strict monitoring procedures," the "full use of the excessive-deficit procedure" and the "application of rigorous accounting rules" to underpin this process.  Again, these comments suggest that the Bank is waiting for further fiscal tightening steps before embarking on an easier monetary policy stance.  Thus, the exchange of pleasantries between fiscal and monetary policy makers continues.

Interest Rates Matter

The Bulletin also contains an article summarising extensive work by ECB and NCB researchers on the monetary transmission mechanism in the euro area.  Some of the more interesting conclusions are as follows:

* A 100-bp change in short rates can be expected to lead to a change in GDP growth of between 0.2 and 0.4 percentage point (pp) in the first year and between 0.4 and 0.7 pp in the second year.

* Due to the existence of balance sheet effects in monetary transmission, the economy responds more sharply to rate changes during recessions or near-recessions than in booms.  In other words, the impact of a rate cut in times of economic weakness in economic growth is larger than the numbers above suggest, and the impact of a rate hike during booms is smaller.  Taking this together with the fact that the equity slump has considerably weakened companies' and households' balance sheets, this suggests to us that any easing of monetary policy in current circumstances could have a disproportionately positive impact on GDP growth.

* The main avenue by which rate cuts affect the economy in the euro area is investment spending.  Over a three-year time horizon, the ECB's model simulations suggest that about 80% of the total impact on GDP from a rate cut would come through investment spending.

* The ECB finds no conclusive evidence for systematic differences between euro-area countries in policy transmission.  Thus, by and large, monetary policy changes should affect the EMU members in a roughly similar fashion.  However, one chart in the article shows the comparatively large impact of interest rate changes on German output during downturns.  If so, any easing of ECB policy in the current environment should benefit the (particularly weak) German economy more than those of its neighbours.  Needless to say, though, the ECB conducts policy for the euro area as a whole, not for individual member states.

Bottom Line

All in all, while this Bulletin would not stand in the way of a rate cut before year-end, we still believe that the ECB will cut rates later rather than sooner, unless of course it is shocked into action by a renewed equity slump, a US double dip, a shock appreciation of the euro, or a major financial accident.

The Dutch government coalition between the Christian Democrats (CDA), the Liberals (VVD) and the List Pim Fortuyn (LPF) has collapsed only 87 days after it was installed. The Dutch government crisis constitutes another potential obstacle on the road to EU enlargement, on top of this weekend's Irish referendum.  We expect the Dutch caretaker government, and a new Dutch government, to support a ten-country enlargement, but there are increasing risks of a short delay in what is currently a very tight timetable.

With new parliamentary elections likely in mid-December or January at the latest, the current coalition, excluding the two LPF ministers who have resigned, will act as a caretaker government in the meantime. While Dutch caretaker governments are expected to refrain from decisions on 'controversial' subjects, this may be (and has been in the past) interpreted flexibly.  As head of a caretaker government, Prime Minister Balkenende will need a majority vote in the parliament next Wednesday to be able to endorse EU enlargement at the Brussels summit.  While the CDA supports a wide enlargement, the coalition partners VVD and LPF have expressed concerns about the inclusion of Poland, Slovakia, Latvia, Lithuania, and Cyprus in the first wave.  The two parties have suggested that extra guarantees should be required against backsliding, and that separate agreements should be signed for the different countries, instead of one treaty for all ten.  We expect that Jan-Peter Balkenende will win support from parliament next week.  The main opposition parties seem to support the Commission's standpoint, and these would be enough for a majority with the CDA.

We do not think the Netherlands would be willing to block the enlargement process.  Recent opinion polls suggest that current coalition partners CDA and VVD would have a narrow majority in the next elections, while the LPF, the strongest opponent of enlargement, is likely to incur significant losses in the new elections.  However, the opposition parties will likely hold out as long as possible on the issue of agricultural subsidies before giving their final approval.  Their concerns regarding the agricultural subsidies should continue to figure in their election campaigns.

The timetable for finalising the details of EU enlargement is already tight.  Assuming a yes vote in Ireland, at next week's Brussels European Council (October 24-25) member state governments are due to endorse or reject the Commission's (positive) assessments of the leading ten candidates for accession.  They were also due to present a Draft Common Position on financing agricultural support.  While agreement appears close on the overall level of transfers, the implications for longer-term agricultural policy remain controversial.  The Dutch government, a large net budget contributor, has been prominent in pushing for a guarantee of CAP reform after 2007 in return for approving a phasing-in of direct subsidies for new members.  With negotiations between the French and German governments apparently still deadlocked, there is no indication as yet that agreement can be reached at Brussels, even with cooperation from the Dutch.

By the Copenhagen Council (December 12-13), the European Commission timetable envisages the conclusion of negotiations with the ten leading applicants.  A single Accession Treaty could be finalised six weeks later, followed in turn by a formal Commission Opinion on enlargement, assent from the European Parliament, and confirmation from the Council.  The Commission envisages giving its opinion in February 2003, and the Treaty being signed in spring 2003, leaving time for ratification by member states and referenda in the applicant countries.  Were the Netherlands to withhold final approval until a new government is in place, we could see final accession slipping into the second half of 2004 or January 2005.  We do not expect Poland or the other named countries to be excluded, given strong political support from Germany and their strong progress against objective criteria.  We also do not see such a limited delay having a significant market impact on the rest of central Europe.

As exports lost pricing power after the Asian Financial Crisis, East Asian economies were encouraged to shift to domestic demand for economic growth. We argued that there could be a secular lift to the region's economies in this transition, which would involve a declining national gross savings rate (see "Sustaining Growth Beyond the Cyclical Rebound," Global Economic Forum, July 28, 2000). The key to this transition is to boost the share of household income in GDP. That is possible if the return on capital is increased and the corporate sector gives its surplus cash to shareholders, which contributes to household income.

Two misunderstandings on this issue are common in the market. First, domestic-demand-led growth is a low-growth model. Some investors advocate continued growth by shifting to domestic demand but ignore its implications for the potential growth rate, which is ultimately the sum of the labor productivity growth rate and the labor force growth rate. In the export-led model, workers in a low-wage economy learn to work like their counterparts in rich economies. Hence, labor productivity rises rapidly if these workers are successful.

In the domestic-demand-led model, workers learn to please their fellow workers who earn the same salary. It is a much harder task. This is why domestic-demand-led economies have a low labor productivity growth rate (i.e., 1.5-2.5% compared to 5-7% in an export-led economy). Hence, if an economy is indeed shifting to domestic demand, the market must adjust its growth expectations. The market is wrong in expecting Korea to sustain a 6-7% growth rate based on domestic demand, in my view.

Let's illustrate this point through the contrast between supermarkets and automobile manufacture. Some argue that Korea can extract much growth from consumers by shifting from wet markets to supermarkets. The presumption is that, if automobile exports don't grow much, this sort of potential will pick up the economic slack. The productivity implication, however, is less growth in the shift. When Korean cars are exported to the US, some Korean workers reach productivity similar to that of their counterparts in Detroit, whose wages happen to be three times as high. But the customers that shop at the new supermarkets have the same salaries as its sales clerks.

This conclusion has major market implications. The Korean stock market offers half as much in dividend yield as the Australian market. Korea's economic transformation will ultimately make it more like Australia in terms of both per capita income and growth rate. Why should Korea be so much more expensive than Australia?

Of course, many analysts want to look at the P/E ratio, etc. I am not sure that it means much. If an economy has low growth and its companies don't want to give the surplus cash back to shareholders, what does it tell you about corporate governance? In today's world the best indicator of valuation for a market as a whole is dividend yield, in my view.

Second, the shift to consumption is effective only if household disposable income rises as a share of GDP. A rising fiscal deficit or a declining household savings rate in response to a property bubble isn't a sustainable force for economic transformation. Worse, a credit bubble like Korea's exaggerates the economic growth rate, and its balance sheet impact will likely slow the economy for years to come.

The shift to consumption has indeed taken place in most economies in East Asia, but its drivers have been quite different from what we expected. Changes in the fiscal balance (e.g., in Singapore) or property bubbles (e.g., in Korea) have played bigger roles than rising returns on capital. One major reason is that the environment has been hostile to substantially boosting returns on capital. Even though the corporate sector has done more restructuring than expected, the deflationary environment has partly neutralized its impact on profitability.

The main source of deflationary pressure has been declining export prices; US import prices for goods from the Newly Industrialized Economies of East Asia have declined by 3% in the past year after declining by 16.3% in the preceding four years. Declining export prices in the past year have not been met by sufficient volume increases. Despite the recent export recovery, the current value of Taiwan's exports is 15% below that in 2000; Singapore's, down 14.3%; and Korea's, down 6.3%. The bad news is that the current export cycle has already peaked.

Exports have become a declining cyclical business in East Asia with the exception of China. As exports drive labor income in East Asia, current conditions represent a strong headwind against income redistribution. Like it or not, the economic transformation in East Asia has to take place in a deflationary environment, which makes corporate governance even more important. If Asian companies refuse to give their surplus cash back to shareholders, their restructuring benefits cannot be felt fully by the economies here. I believe governments in the region must act to strengthen the role of corporate boards of directors.