There is no escaping that monetary policy is a very complex subject matter, difficult to apply and much more than a simple idea of targeting an appropriate inflation rate. The monetary authorities are not innocent for they can easily make mistakes and clearly bear a lot of responsibilities for the consequences of their policies on the behaviour of the financial markets and economic activity.
On the one hand, should the monetary stance be easy at a time when it is tight, market prices of risky assets would rise, government bond yields would increase, the value of the home currency would decrease in term of gold, and inflationary expectations would increase. On the other hand, should the monetary stance be tight at a time when it is easy, market prices of risky assets would decline, government bond yields would decrease, the value of the home currency would increase in gold terms, and inflationary expectations would decrease. Of course, the longer the conduct of monetary policy, and the more far away it is from what it ought to be, the more dramatic will the unintended consequences be.
To properly judge the effect of monetary policy on things that matter to investors, one must know and understand that monetary policy is not asymmetric but somewhat chaotic. A much better way to judge which monetary stance the central bank should conduct is to have the common sense of taking a more macro economic approach.
Based on historical repetition, monetary policy should be neutral when prices are stable, fiscal budgets are in balance, the balance of payments is viable, employment is full and economic growth in nominal terms equals closely, population and productivity changes. There is ample empirical evidence and theoretical validity that for any given deviation in the above factors it should tilt the monetary stance away from even keel. If it`s not done, the Central Bank is not counteracting the pro-cyclical forces of finance, thus creating risks or opportunities to investors.
Palos Management’s US monetary policy index which takes into account all of the aforementioned factors calculates that the monetary stance of the US Fed should be slightly on the tight side of even keel. On January 22, 2010 the index stood at 115. Neutral is 100 and less than 100 is easy. Yet, the US monetary stance is clearly easy for the yield curve is steep, the federal fund rate is way below the rate of inflation and the FRB has flooded the banking system with a massive expansion of the monetary base. If it had not been that the economy was in the throes of writing down huge amounts of bad debts, the money supply (MZM) would have doubled.
Theory predicted correctly the debasement of the US dollar in gold terms, the surge in the market prices of risky assets, the rise in government bond yields and the increase in inflationary expectations in 2009 and the early weeks of 2010. The question is will the monetary stance of the FED turn in 2010. If the FED does not, more of the same can be expected. But, should it adopt a tighter stance, as we believe it will, than a more sober market for risky assets, a more stable US dollar and more increases in government bond yields can be expected.
Consequently, the beginning of the exit from super-expansionary monetary policies will be one of three dominant global macro themes in 2010 along with fiscal and global imbalances. The last weekly letter dealt with US fiscal deficits and next weekly letter will address the global imbalances between the US and the rest of the world. I’m of the opinion that the monetary stance will be gradually moving toward neutrality in 2010 and to an even keel position in 2011. Investors should watch what might happen to quantitative easing for that’s the 800 pound gorilla in the room. The FED, in our opinion, is likely to stick to it’s stated plan to end purchases of mortgages at the end of March and roll back emergency lending programs in February.
The FED will be saved by the private sector and China in that they will take up the burden of financing government budget deficits. Private savings will substantially increase over the next few years because of the ongoing de-leveraging process of households, financial institutions, commercial real estate and non-financial corporations. The private sector could buy as much as $1000 billion of US treasuries in 2010.
The monetary authorities in China abruptly reversed course last Tuesday in a clear sign that they have turned their attention to controlling the repercussions on of a credit explosion by raising reserve requirements on banks and yields on short term bills. The money supply in China is up 35% on a year to year basis. These changes mark stage one and the turning point of China’s exit from emergency policies. Because China, for all intents and purposes, is under a fixed exchange rate in that its currency is linked to the US dollar; a tighter monetary stance should lead to upward pressure on the Yuan and, therefore, lead to more accumulation of international reserves in the form of US Greenbacks. China and other foreign countries may buy as much as $500 billion worth of US treasuries in 2010.
What these two sources of financing means is that the FED will be able to follow a monetary stance that will be more in tune with what it ought to be. The US economy may have ended 2009 with a bang, but the anticipated change in the fiscal and monetary stance means that the 2010 outlook will be mute for a post recovery year.
Hubert Marleau, Chief Investment Officer