Risks, Hedges & Opportunities: Central Banks

Guest post from Hubert Marleau, Chief Investment Officer, Palos Management Inc.

Uncertainty is everywhere but found mainly in the western world where external and budget deficits are large and unsustainable over the mid-term. The US is burdened with these deficits but it finds itself in an exceptional position. It is somewhat insulated enough to be considered a safe haven. Thus, the US has been allowed more time by the marketplace and bond vigilantes to deal with the correction of public debt and deficit spending. This is, of course, much different than the Euro-zone.

In this connection, the US has decided to take a more gradual path of financial repression in the hope of curing leverage problems through economic growth. For the most part, it seems that it has worked. People that have taken to the streets demanding greater social justice, fairer economic systems, flatter incomes and fewer wealth inequalities have been more violent and aggressive in the Euro-zone than in the US. We attribute this visible difference, perhaps in an oblique and indirect fashion, to how the application of monetary policy differs between the US and Euro-zone.

It is plainly evident that in the US, the monetary stance has been significantly easier. Since the start of the financial crisis in 2008, the amount of assets on the ECB’s balance sheet increased about 80%, which may be viewed as a lot, but is far less than the 200% at the FED and, for most part, the FED has kept the cost of money about 50 to 100 bps lower than the ECB has. Yet, the Federal Reserve Board has not lost credibility and reputation nor the confidence of investors for using maximum financial power in its attempt to prevent the worst from happening. In fact, it did better than just escape an economic tragedy–it ended up in creating an economic recovery.

The consensus view is that the US will grow between 2.0% and 2.5% in 2012 compared to 0.0% and 0.5% for the Euro-zone. Rational expectation theory as well as monetary theory would argue that productivity can only go up when unused and idle capacity is continuously pushed by easy money. For some time now reliable indicators have been improving impressively.
1) The annualized growth rate of the smoothed ECRI weekly index has not stopped rising since the beginning of September;
2) The Conference Board index of leading indicators rose 0.9% in October and it has done so since last April;
3) Commercial Bank Credit, out of thin air, has started to accelerate at the annual rate of 7.0% since June 2011;
4) The pace of initial jobless claims has been easing for some time now. The four-week moving average has receded to 396K, the first time it has been below the 400K threshold since April.

Overall, these indicators are an encouraging sign that the recovery is ongoing and will maintain recent improvements. The US economy appears to be finding its stride despite the European debt crisis. The probability of a second dip or just a plain recession is becoming less likely. Moreover, the housing sector is showing some life. Building permits jumped 11% in October, the fourth gain in the past six months. Imagine a turnaround, even a mild one, in residential construction. A real probability for the fall in housing prices has been so dramatic that affordability is better than it has been for decades.

What is most remarkable is that even though the Fed lowered the cost of money to zero and created $1.65 trillion of excess bank reserves, there has been no substantial risk to price stability. Recent data points show that both actual price inflation and inflationary expectations are decelerating.

We all know and understand that the Germans are hard-nosed on letting the ECB run wild and halt the profligacy of many peripheral euro-zone members that have been politically dysfunctional and recklessly extravagant. But, eventually a middle-of-the-road compromise will ensue for there is too much empirical evidence and theoretical validity that the potency and power of a Central Bank can address financial crisis.

While there is genuine concern that huge buying programs by a central banker can lead to major inflationary problems, this only occurs under normal circumstances. It would be terribly difficult to disapprove the notion that if the ECB was to act as a lender of last resort that the actions would be inflationary. To put it succinctly, austerity measures combined with de-leveraging balance sheets and unused capacity is as deflationary as cranking up the printing machine is inflationary.


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