-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it "fair" value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for "risky" currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and "bubble" forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

-David Kuo, Director at the financial website The Motley Fool. The opinions expressed are his own.-

Go on. Admit it. You didn’t see it coming, did you? You never thought a member of the G20 nations would dare to break ranks and raise interest rates this soon.

But Australia has done just that. The Central Bank of Australia has increased the cost of borrowing by 0.25 percent to 3.25 percent. It is doing what it thinks is right for the country regardless of what the rest may think. Now, Asian countries, keen to avert another bubble, may follow Australia’s lead and ratchet up interest rates before long.

Of course, Australia’s economy is vastly different to the UK’s. It has huge deposits of iron, aluminium and nickel that are in demand by mineral-hungry China. That said, Australia did briefly flirt with a downturn, which it successfully corrected with 21 billion pounds of fiscal stimulus.

But the UK is not Australia. We do not have huge deposits of mineral, and we are not near fasting-growing Asian countries either. What we do have are consumers saddled with over a trillion pounds of debt following a decade of binge borrowing, and a national debt burden of similar magnitude.
Therefore, it is unlikely that we will experience demand-led inflation. In fact, consumers are saving more of their household income than they have done for eight years.

The most recent Office for National Statistics report shows that between March and June British households saved 5.60 pounds out of every 100 pounds of household income. That is very different from the first three months of 2008 when we not only failed to save any money, but we even borrowed 50 pence for every 100 pounds of household income.

That said, we are still some way off getting our overstretched household finances back on an even keel. So, the savings ratio could go higher. In fact, it is still some way short of the long-run savings-ratio average of 8 percent of household income.

And herein lies the problem for the Bank of England.

According to the paradox of thrift, high levels of savings in a recession can prolong the economic downturn. That is because two-thirds of economic growth comes from consumer spending. So the less we spend, the longer it will take the UK economy to recover from the slump.
So what is the Monetary Policy Committee to do?

It has already slashed interest rates to historic lows. But that has failed to stimulate consumer spending. It has pumped 158 billion pounds of fresh money into the coffers of lenders through quantitative easing. But the money has, as yet, failed to invigorate the ailing economy.

However, both those measures will, in time, achieve their goals. The risk is not whether they will work, but instead, whether they will work too well and stoke inflation. Just as no one expected Australia to hike rates this soon, our days of enjoying low interest rates may end just as abruptly, and without warning. So save and invest what you can now.

– John Kemp is a Reuters columnist. The views expressed are his own –

The Bank of England’s decision to continue with its asset purchase programme, or quantitative easing (QE), at the rate of 50 billion pounds per quarter in Oct-Dec, unchanged from Jul-Sep, shows bank officials are more worried about ending support for the recovery too soon than about risking inflation by leaving it too late.

The problem with QE is that you have to keep buying the same amount of assets each month to maintain the same monetary stance. With interest rates, the Bank can cut them and they stay cut. If asset prices drop with QE, it represents a tightening of monetary policy.

The Bank initially bought 75 billion pounds in the first 3 months (Apr-Jun) and then tapered this to 50 billion in the second three months (Jul-Sep) as the crisis engulfing the banking system and the rest of the economy eased. A cautious approach might have tapered the QE programme again to 25 billion in the final three months of the year before ending it entirely at the start of 2010. But the Bank opted to stick at 50 billion.

Critics point out that the programme has not achieved its announced objective of increasing bank credit and the amount of money in circulation. The rate of growth in M4, the broadest money supply measure, has risen only marginally. But that ignores the counterfactual of what would have happened to M4 in the absence of the programme — it might have fallen sharply.

Growth in the monetary aggregates is, in any event, mostly endogenous. It depends on demand for credit. In the current environment, where many households and businesses have little or no collateral, credit is impaired, and most are focused on paying down debt rather than adding to it, limited growth in M4 is not surprising. Trying to make it grow faster is like force feeding a duck to make foie gras — possible but unnatural.

QE has always been as much about restoring confidence, dispelling fears about deflation and ensuring a ready market for the safer securities banks hold as much as growing the money supply. On most of these measures it must be considered a qualified, if expensive, success. A full judgement will only be possible when the Bank has proved it can withdraw the excess liquidity in a timely manner to prevent an upsurge in inflation.

In the end, the decision to press on is driven by fears about the fragility of the current recovery, and the risk that if QE ends too soon, effectively tightening policy, whatever green shoots have emerged over the summer will be killed off by an autumn frost.

All recoveries are fragile and weak early on. While the rebuilding of inventories along the supply chain, often provides the initial boost, this must eventually be replaced by a more sustained increase in household and business expenditure.

But with their new focus on the experience of the 1930s, central bank officials worldwide are more worried than normal about doing anything to stall the recovery.

Looming over the debate is the experience of 1937, when the Federal Reserve responded to concerns about the amount of “excess liquidity” in the banking system and sharp rises in the price of some commodities, especially steel, by doubling reserve requirements on banks in the space of nine months. It effectively converted previously “excess” reserves against which the banks could lend into “required” reserves against which they could not.

The four-year old recovery (1933-1937) promptly collapsed amid tightening bank credit, and the United States suffered the second deep recession in a decade, with output not fully recovering until the onset of war in 1940-41 (https://customers.reuters.com/d/graphics/DSTMIRROR.pdf).

Anxious to avoid a repeat, it is no wonder that the Bank of England is in no hurry to tighten policy. While this level of QE must eventually generate inflationary pressures, the Bank judges, probably correctly, that it still has some time before policy needs to move to a more restrictive setting.

-- John Kemp is a Reuters columnist. The views expressed are his own --

LONDON, April 9 (Reuters) - The Bank of England's terse press statement announcing it will maintain overnight rates at 0.5 percent and continue the existing 75 billion pound quantitative easing (QE) programme gives no clue about whether the Bank intends to extend the programme when the first tranche of asset purchases are completed in June.
But officials will have to make a decision soon: unless they signal a commitment to extend QE, gilt yields will rise even further in anticipation that the major buyer in the market will withdraw.
The QE programme is dogged by ambiguity about its objectives (which a cynical observer might conclude is deliberate).
Officially, the aim is to prevent inflation falling below target by accelerating money supply growth, not manipulate the yield curve for government and corporate debt.
In this, the Bank's avowed strategy is more conventional than the Fed's ambitious efforts to determine the cost of credit for borrowers throughout the economy. It is a straightforward quantitative easing patterned on the Bank of Japan, rather than a credit easing patterned on the Fed.
If true, the measure of success is how much the money supply has been boosted at the end of the three month period; the Bank should be indifferent about whether ending QE causes yields and borrowing costs to rise.
So long as money supply has risen consistent with the inflation target, and the Bank can discern some green shoots of stabilisation if not recovery, officials can declare victory, end the programme, and keep the other 75 billion pounds of asset purchases authorised by the chancellor in reserve. Yields can be left to find their natural level.
But many suspect the Bank's real objective is yield control -- in which case it will have to announce another round of buy backs of gilts and corporate bonds in good time, well before the current programme is completed, to shape market expectations.
The results of the existing round have been unimpressive.
After falling initially, gilt yields are almost back up to the level they were at before the Bank's foray into unconventional monetary policy.
The snag is that if the Bank stops buying, other investors will struggle to absorb all the new government paper on offer without a major increase in yield -- pushing up borrowing costs for everyone, precisely what the Bank has sought to avoid.
The Bank's dilemma is whether to push on (heightening fears about inflation) or call a halt (risking a spike in yields all the same).
Either way, the Bank needs to give the market, as well as the Treasury and the Debt Management Office, plenty of warning about its intentions.
(Editing by Richard Hubbard)

-Alan Clarke is UK economist at BNP Paribas. The opinions expressed are his own-

As expected, the Bank of England left the Bank Rate unchanged at 0.5 percent at the April meeting, the first unchanged decision since September 2008.

The accompanying statement was short and sweet. The Bank has accumulated 26 billion pounds of asset purchases and will take a further two months to complete the planned 75 billion pounds of purchases - see you next month!

It is disappointing that gilt yields haven't remained low - partly because of firmer economic data, but also because the market is wary of the exit strategy. Hence the statement was a bit of a missed opportunity. The Bank has run out of interest rate ammunition and hence is having to use alternative measures including quantitative easing. Some form of verbal intervention, voicing a desire to get gilt yields lower could have been a cheap and easy way to loosen conditions in the economy.

Ultimately we expect the scale and duration of quantitative easing to be more than most expect. Our models suggest that if the Bank Rate could fall below zero, interest rates "should" be -4 percent. That shows the magnitude of the stimulus that is required from unconventional policy. Given this, we expect Bank purchases of assets to amount to as much as double the 150 billion pound that the Bank is currently authorised to spend.

Quantitative easing is called unconventional policy for a reason. It is the last resort. We don't know if it will work; if it does work we don't know how well it will work or how quickly it will work; we don't know how big any side effects will be. If it was so fast and effective then it wouldn't be unconventional - we wouldn't bother moving the Bank Rate, we would use QE instead.

The point is, it is going to take a long while before we discover if QE has worked. The typical lead time between interest rates and the economy is 12 to 18 months. Hence as a starting point, that is the horizon over which we should be able to conclude whether the programme of asset purchases has worked.

The definition of whether it is working is a little blurred. The lion's share of the fall in gilt yields since QE began has since been reversed. Hence if one objective was to lower market interest rates, it is hard to conclude that the programme has been a success. The situation was not helped by comments from Bank Governor Mervyn King that frightened the market into positioning for the exit strategy barely five minutes into the QE programme.

One area that the Bank will be encouraged by is the compression in non-financial corporate bond spreads relative to the eurozone (where asset purchases have not begun). This, and the narrowing in the liquidity premium are potentially helpful in facilitating easier financing conditions for companies. Judging whether the availability of credit more widely to firms or households has improved since QE started will take much longer.

– Lena Komileva is Head of G7 Market Economics, Tullett Prebon –

One of the big historical lessons of this crisis for economic policy is that bringing down the risk-free cost of money - central bank rates or government bond yields - and injecting liquidity into the banking system cannot on their own fix broken credit markets.

Quantitative easing by central banks may help to solve short-term liquidity problems for domestic borrowers and lenders, by going around broken markets during times of extreme financial and economic uncertainty. However, this is no substitute for efforts to restore international credit markets back to health.

Effective policy measures would contain the economic fear and channel private sector incentives – the foundation of free markets - in a way that alters the behaviour of lenders, companies and consumers. The end-game policy strategy cannot be to replace free markets.

So why have traditional monetary stimuli failed to end this crisis? And what should be done next?

The textbook understanding of the relationship between easier central bank money and the supply of liquidity in the broader economy assumes that there is a direct, causal link between banks’ capacity to generate credit and actual lending growth.

However this assumption ignores two important factors – 1) lenders’ incentives and 2) the role of international credit markets, which have come to dwarf traditional bank lending over the past decade.

Credit generation is linked directly to lenders’ perceptions of their profitability, i.e. their risk-adjusted returns. This in turn is determined by borrowers’ financial viability and the value of private sector collateral, provided as insurance for loans, both of which have suffered unprecedented erosion since asset-backed securities (ABS) markets broke down in 2007.

Hence policy efforts focused on the cost of money or lenders’ liquidity have helped to alleviate the effects of the crisis in the financial sector but have so far failed to resolve the causes - fragile investor sentiment and illiquid and dislocated interbank and credit markets. Since these are the forces behind the recessionary disruption of confidence and liquidity in the real economy policy carries a big responsibility.

Over the past several months, liquid and recapitalised banks have continued to shed risk and limit loan growth, despite historically low Libor rates and government bond yields. Even with government efforts to underwrite bank capital and toxic assets, disrupted international investment flows, a global recession and falling credit ratings continue to depress the value of bank assets. Hence lenders and investors have remained exceptionally cautious about the risks that they take on their books.

A glance at G7 monetary statistics reveals the limitations of quantitative easing. In the UK, the voluntary reserves held by banks at the Bank of England surged by 73% year-on-year in February. Yet lending to the household sector contracted by 5.5% and loans to private non-financial corporations rose just 2.1%, the lowest pace in over 6 years. If the uncertainty about credit markets and the economy continues, then corporates and consumers will also adopt lenders’ tendency to build up excessively high levels of precautionary savings.

The risks attached to quantitative easing in an international crisis are not immaterial. Failure to restore the confidence of financial institutions to lend and of companies to invest and hire would lead down the road to a liquidity trap, an environment in which excessive monetary liquidity coincides with a depression in the real economy.

As always, where there are economic risks there are also financial risks, and vice versa. If central banks’ interventions to change private sector financial valuations, for example corporate bond spreads, through asset purchases do not improve the fundamental position of the borrowers, i.e. their ability to raise finance freely in the markets and their economic environment, then investor concerns about a new asset bubble will  follow. In a worst case scenario this could lead to a currency crisis as investors flee the domestic market.

A NEW POLICY TOOL NEEDED

The most important lesson from this is that the causal links between depressed lender incentives, disrupted financial liquidity and the international economic turmoil are the forces at the heart of this crisis. An effective policy strategy would go directly to the root of the problem by reducing borrowers’ default risk and so support the regeneration of healthy asset-backed securities markets. This in turn would reduce financial asset volatility and strengthen lenders’ balance sheets. Reduced counterparty credit risk and enhanced market transparency would boost investor confidence and involvement in credit markets and lower private sector borrowing costs.

The way to build this new economic equilibrium is for governments to insure ex ante the “excess” portion of borrowers’ risk associated with the disruption of national and international financial flows. This is about a blanket guarantee scheme which eliminates financial illiquidity risk premia attached by lenders to new private sector loans in cases where markets are malfunctioning.

Central banks can support this credit easing strategy by acting as market makers for structured notes, i.e. bundles of new “insured” corporate and consumer loans. This would ensure liquidity in secondary markets.

Since we first made this argument at the start of 2009, Western governments have announced a constellation of schemes that seek to free up finance in the real economy. The Fed has launched a $1trn Term Asset-Backed Securities Loan Facility (TALF) scheme and the Bank of England has launched credit quantitative easing. There are important steps that will materially improve market conditions, but more is needed.

On a G20 scale, the global crisis requires coordinated policy measures that effectively stimulate balanced international capital flows. These cannot come from stabilizing national banking sectors alone. What are needed are measures to open domestic credit markets to international investors.

THE BENEFITS

The primary benefit of this strategy would be the restoration of market liquidity through incentives that mobilise private sector funds, rather than through increased government borrowing or central banks printing money.

Government guarantees to new loans would have the dual effect of reducing private sector borrowing costs and improving lenders’ expected asset quality and profitability. This would support liquidity in a wide range of correlated markets, from equities to interbank lending.

Since this strategy would also support healthy securitisation activity, it would help to re-open domestic credit markets to the international investor community. This would improve domestic market liquidity and propagate the role of markets rather than individual institutions in the credit cycle.

This would also help to insulate economies from future disruptions in the domestic banking sectors and begin to tackle the problem of banks that are “too big to fail or save”, reducing the cost to the taxpayer.

This strategy focuses on fixing private sector incentives, not on crowding out free markets with public funds. By leaving a manageable portion of risk in the markets, governments can reduce the moral hazard associated with guaranteeing private sector risk and reinforce the incentives for banks to introduce stringent risk monitoring controls, in effect strengthening macro-prudential regulation.

Governments’ claims on borrowers’ collateral in the event of default (and in exchange for a cash payout to the lender) would also serve the purpose to deter asset fire-sales by lenders and hence reduce future risks to market liquidity. Since government insurance conditionality would not prevent irresponsible borrowers from failing, this would also strengthen the structural foundation of the economy by purging private sector balance sheets.

A big advantage to this scheme is that there is no a priori commitment to government borrowing. Reduced systemic risks, a repaired monetary transmission mechanism, and restored investor and producer confidence would instead reduce public sector liabilities.

Another significant benefit of this strategy is that it contains the seeds of its own destruction - once market illiquidity premia have dropped to zero and borrower default rates have stabilized government guarantees will, by default, become redundant. That said, an enhanced policy framework that recognizes both the fundamental (growth and inflation) and the financial (momentum and liquidity) factors in the credit cycle would strengthen confidence in economic policy and act as an “automatic stabiliser” for the economic cycle, reducing the chances that future market corrections will mutate into crises. Continued focus on financial risk premia would send a signal that policy is monitoring and prepared to intervene in both future credit “bubbles” and “anti-bubbles”.

G20 governments have a golden opportunity to address the root cause of the current credit crisis at their London summit. It is time for them to extend asset insurance schemes to new private sector loans to bring the international credit crisis to an end, limit the costs of their bank bailout programmes and reduce the probability and damage associated with future financial crises.

– James Saft is a Reuters columnist. The opinions expressed are his own –

The dollar is, and will remain, the U.S.’s currency and its own and everyone else’s problem.

The idea of creating a global currency, as espoused by China earlier this week, is interesting, has a certain amount of merit and is simply not going to happen any time soon.

U.S. desire for free access to the cookie jar that being the world’s reserve currency represents will be too strong, especially given its need to finance huge amounts of debt reasonably cheaply. As well practicalities are fearsome, even if consensus was more or less there.

Chinese central bank head Zhou Xiaochuan on Monday called for the creation of a new “super-sovereign” global reserve currency, advocating building on an International Monetary Fund instrument called Special Drawing Rights.

Zhou echoed a call by Russia last week, when it indicated it would raise the issue at the upcoming Group of 20 meeting in London on April 2, saying the idea had support from emerging market economies including Brazil, India, South Korea and South Africa.

There is no doubt that the current system breeds instability, but it enjoys the great advantage of entrenchment and sticking with it allows the U.S., and others, to avoid making hard choices and paying true market prices for their economic decisions.

No surprise then that President Obama knocked the idea down in blunt terms. “I don’t believe that there’s a need for a global currency,” Obama said, terming the dollar “extraordinarily strong right now.”

Exactly. Too strong by some margin, especially when one considers the coming effects of both quantitative easing and a massive long-term need to fund the costs of the debt binge that exploded and the ever increasing bailout to clean up the aftermath.

In fact you could say the dollar’s “extraordinary” strength can only be fully explained when you take into account the fact that foreign central banks keep piling up huge reserves of the thing and that it is the international medium of exchange for commodities and energy, well really for global trade and financial intermediation.

Treasury Secretary Timothy Geithner said on Wednesday the U.S. dollar is still the world’s reserve currency and will remain so for a long time, but expressed openness to greater use of IMF SDRs.

The dollar’s central role has two main implications, both rather ugly but also very seductive for those involved.

For the U.S. it’s a bit of a free ride as far as debt financing goes. People buy and hold treasuries more and the U.S. gets cheaper financing that would otherwise be the case. Of course that’s a bit like an alcoholic bartender getting a discount at work; a real benefit, but not a true one.

It also means that even if the U.S. has the will to take away the proverbial punchbowl or drive the dollar down, it doesn’t always have control, as what it does at the short end of the interest rate curve can be confounded by foreign purchases that keep the long end and financing costs down and the dollar up.

SOVEREIGN OVER US ALL?

The U.S. reserve status also opens up the opportunity for mercantilist countries, like, say China, to keep its own currency cheap, building up huge dollar stocks and force-feeding the American milch cow with cheap credit with which to buy imported goods.

That may not work any more anyway, as all of the cow’s stomachs are full and the milk’s gone thin.
There is a temptation also to build up reserves as protection against bad times and bitter IMF medicine.

Many Asian leaders seem to have vowed after 1997 that they would do what was needed, which often included building up dollar reserves, to avoid having to meet an IMF director’s plane at the airport and accept the accompanying prescription.

That rather indicates that the old system, with the U.S. as global reserve currency, is dying, but I doubt it will do so without a fight and with cooperation among nations willing to cede part of their sovereignty, even for a greater good.

It is amazing and encouraging that China speaks of ceding control of a portion of its foreign reserve assets to IMF management, but I have a hard time seeing it happening widely soon.

So, we will have to get through the next year or two without a super-sovereign currency and with global imbalances being worked out, or around, under the current system.

My best guess is that things actually go in the right direction, more or less. The dollar should weaken as a result of U.S. policy even without a deliberate push downhill from the Chinese. Asian exporting nations will see slowing reserve growth generally, which should translate into diminished flows into the dollar and Treasuries.

That’s going to be painful all around. The Chinese and others will see their investments dwindle, even as they have to resist the impulse to sell into the fall. For the U.S. the process of implementing monetary policy and paying for fiscal policy will be made that much more difficult.

So, goodbye and perhaps good riddance to dollar hegemony, but don’t expect a stable system of global cooperation to rise easily and quickly in its place.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

– James Saft is a Reuters columnist. The opinions expressed are his own –

The Federal Reserve and U.S. economy have two considerable risks now that quantitative easing is at hand: keeping the dollar from a disorderly decline and figuring out how to dismount from the tiger.

The Fed has cut interest rates to a range of zero to 0.25 percent and said it would use “all available tools” to get the economy growing again, including buying mortgage debt as well as exploring direct purchases of Treasuries.

While the central bank was at pains to distance its policy from Japan’s during its extended downturn, there can be no doubt that the dollar printing presses are and have been running and will pump out as much currency as is needed to avoid deflation and make credit available at a stimulative rate.

There is no question of the Fed not being able to re-ignite inflation in the U.S. economy; if they print money fast enough, prices will go up. The issue is more about the collateral damage possible when a major debtor nation takes these steps, even if it is doing it for all the right reasons in support of the best possible cause.

In the short term the risk is that foreign holders of the dollar and Treasuries are spooked by the whirring of the presses, and, reasoning that the Fed cannot fail in its quest to re-ignite inflation, decide to hold something less, well, risky.

Now of course in the current circumstances there may, for better or worse, not be that much of a dollar alternative for global reserve managers and investors and, seeing as how a rapid unwind in the dollar would hurt creditors, they may stick it out.

But the risk is higher now than last week, and much higher than earlier this year.

The value of a dollar against a trade-weighted basket of currencies fell sharply after the Fed’s announcement and is down about 10 percent in the past month.

Two factors that had been supporting the dollar through the recent months of the crisis, a tendency by U.S. investors to repatriate dollars during periods of stress and the need to purchase dollars as part of the process of unwinding leveraged financial trades, will not continue forever.

“The risks for the dollar are pretty clear,” said Michael Hart, a foreign exchange strategist at Citigroup in London. “It is going one way and the only question is how uni-directional it is going to be and how many starts and stops we are going to see.”

IT’S DIFFERENT THIS TIME

U.S. policy appears to be aimed at helping to recapitalize the banks and cutting the cost of finance to consumers by buying up assets and is distinct from that of the Bank of Japan, which increased bank reserves.

There are some key differences between the U.S. and Japan, which didn’t have the same need to attract external finance, and for that matter between the U.S. now and the U.S. during the Great Depression. When the Depression struck, the U.S. was the world’s biggest creditor, rather than its principle debtor.

The U.S. economy is both distended and hollowed out; it needs to redirect itself more toward savings and producing goods and services that can be sold overseas. The problem is that doing that quickly will be both very painful and produce a lot of collateral damage. Fed policy can only succeed if it softens the very terrible impact of that reallocation but does not prevent it.

But what happens if, or rather once, the Fed and the U.S. government’s combined stimulus succeeds? How exactly do you unwind a program of Treasury and mortgage asset purchases and near zero rates without bringing on too much inflation, perhaps much too much?

If foreign holders of the dollar stick with it during the next crucial months, there is little to prevent them from bailing out later, if they judge the Fed to have kicked the ball too far down field. There is no way of knowing how this can be undone or what to expect.

There is also another set of actors who can cause problems; foreign central banks and their government bosses. If the dollar weakens much during a time of global recession many will have a hard time resisting the urge to devalue their own currencies in order to capture a bigger share of what little demand remains.

The plan to buy assets to cut the knot of finance is sound but begs the question of how and when the banking system will be brought back to life. I’m not sure that buying time and hoping it can outlive its debts will work.

The new administration needs to, quickly, enunciate a clear and comprehensive policy on how recapitalizations will work, so that private capital and taxpayers can know where they stand.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. –

– John Kemp is a Reuters columnist. The views expressed are his own –

Like the sorcerer’s apprentice, Federal Reserve Chairman Ben Bernanke and his predecessor Alan Greenspan have unleashed a series of ever-larger asset bubbles they cannot control.

Now the Fed’s decision to cut interest rates to between zero and 0.25 percent, coupled with a promise to keep them there for an extended period, and the threat to conduct even more unconventional operations in the longer-dated Treasury market risks the biggest bubble of all, this time in U.S. government debt.

THE ASYMMETRIC EXPERIMENT

Bubble mania is no accident. It is the direct consequence of the Fed’s asymmetric response to shifts in asset prices. Pressed to “lean against the wind” and adopt counter-cyclical interest rate and credit policies in the asset market, senior Fed policymakers have repeatedly demurred.

Led by Bernanke and Greenspan, officials have argued it is too hard and subjective to identify bubbles until afterwards, and not the Fed’s job to second-guess asset allocation decisions of professional investors.

Even if bubbles could be identified, they argue, pricking them would require swingeing rate rises that would inflict widespread damage on the rest of the economy.

Far less damaging to allow asset markets to follow their natural cycle and stand by to cut interest rates sharply, supply liquidity and contain the fallout when the bubble bursts.

But the Fed’s asymmetric policy response to rising and falling asset prices (colloquially known as the “Greenspan/Bernanke put”) directly led to much of the excessive risk-taking which has humbled the financial system over the last eighteen months.

More importantly, the Fed’s decision to respond to the collapse of the technology and stock market bubble by lowering rates to 1 percent and holding them there for an extended period is now widely accepted as a mistake that contributed to the bond bubble and subsequent housing market boom in the middle of the decade.

If the low-rate strategy was a mistake, it was a conscious one. In testimony to the UK Parliament last year, former Bank of England Governor Eddie George admitted the bank had deliberately sought to stimulate the housing market and house prices to support consumption during the downturn.

Greenspan, Bernanke and Co seem to have adopted a similar approach in the United States.
The real mistake, however, was not creating one bubble to offset the collapse of another, but believing they could control what they had wrought.

When the Fed did eventually start to raise short-term interest rates in 2004, long rates remained stubbornly low for a year, and then rose much more slowly than anticipated, a development the puzzled Fed chairman and his able assistant Dr Bernanke described as “the Great Conundrum”.

Even as rates eventually rose, the alchemy of securitization ensured the real cost of credit remained far too low until the subprime bubble finally burst in late 2007.

The second mistake is a basic design flaw in the Fed’s “risk-management” approach to setting monetary policy. Risk management is a nice idea, but not terribly useful. As engineer will explain, risk management involves trade offs and is not cost-free.

The Fed has struggled to formulate a response to “low probability, high impact” events such as the threat of deflation in the early 2000s. Its response has been to cut rates aggressively to ward off the danger of extreme downside events, a strategy officials liken to taking out an insurance policy.

That’s fine, but when these low risk events have not in fact occurred, as was never statistically likely, the resulting policy settings have proved far too loose, and the central bank much too slow to change it.

Concentrating on theoretical but small risks such as deflation has too often blinded the Fed to much larger risks near at hand of bubbles and asset inflation.

INTO THE UNKNOWN

Even as officials recognize policy has played a role stimulating an endless series of bubbles, the Fed finds itself trapped with no way out. Following the collapse of much of the modern banking system, the risk of pernicious deflation is now very real–more so than in the early 2000s.

So like the sorcerer’s apprentice, the Fed has cranked up the Great Bubble Machine for what policymakers hope will be one final time.

The Fed’s “unconventional” monetary strategy comes in four parts:

(1) Cutting interest rates to near-zero to lower the cost of borrowing.

(2) Injecting short-term liquidity into the financial system in the form of bank reserves (quantitative easing).

(3) Trying to pull down yields on longer-dated Treasury bonds through a combination of the jawbone (promising to keep short rates low for an extended period) and the threat to intervene in the market directly by buying longer-dated paper.

(4) Trying to reduce credit spreads above the Treasury yield for other borrowers, and increase the quantity of credit available, by buying mortgage-backed agency bonds for its own account, and financing other market participants to buy securities backed by other consumer credits, auto loans and student loans.

Most attention has focused on the zero-rate policy and quantitative easing at the short end of the curve. But the real significance lies in the unconventional operations targeting Treasury yields and eventually credit spreads at the long end.

Operations at the short end are designed to bolster the banking system and restart lending. But the Fed knows the banking system is not large enough to replace the much more important sources of credit from securities markets.

Operations at the long end are designed to get bond finance and securitized credit flowing. Short-end interest rates and quantitative operations are significant because they help shape the whole term structure of interest rates embedded in the curve.

ONE LAST SUPER-BUBBLE

The strategy has already succeeded in halving yields from over 4 percent in mid October to just 2.25 percent now.

By convincing investors interest rates will remain ultra low for a long period, the Fed has made them willing to lend to the U.S. government for up to ten years for what is a paltry return.

There are two risks. First, the massive rise in bond prices and compression of yields has come in the secondary market. The U.S. Treasury has not yet succeeded in placing much of its massively expanded debt and new requirements for next year at such low levels. But given the panic-driven demand for default-free assets, officials should not have too much difficulty.

The bigger one is that the Fed is misleading investors into the biggest bubble of all time. Bernanke is making what learned economists call a “time-inconsistent” promise to hold interest rates at ultra low levels for an extended period.

The problem is that if the unconventional monetary policy works, and the economy picks up, the Fed will come under pressure to “normalize” rates and reduce excess liquidity to prevent a rise in inflation. The resulting rate rises will inflict massive losses on anyone who bought bonds at today 2.25 percent rate.

Bizarrely, Bernanke and Co are in fact inviting investors to bet the policy will fail, the economy will remain mired in slump for a long period, deflation will occur and interest rates will remain on the floor, as Japan’s have done since the 1990s.

Buyers of real estate and subprime securities have recently been lampooned for foolishly overpaying at the top of the market. Bernanke and Co are gambling memories will prove short and investors will prove just as eager to pay top prices for long-term government and private debt even though the downside is large.

Let us have one last bubble, and when it collapses, we promise not to do any more in future…honest.

For previous columns by John Kemp, click here.

– James Saft is a Reuters columnist. The opinions expressed are his own –

With the U.S., Japan and Britain — nearly 40 percent of the global economy — facing the threat of deflation, it’s going to be just too easy for one, two or all three of them to get the policy response horribly wrong.

The global economy is so connected, and our experience with similar situations so limited that the scope for error is huge.

Think of it as having three pilots flying a jet plane, one each operating a wing and the third managing the tail.

Oh yeah, and they all work for different airlines.

Though there will be much talk of international coordination in the next year, and though the central banks and governments of the world will likely be rowing in the same direction, their ability to gauge the effects of monetary policy and government spending on their own economies will be pretty limited, and even more so on the whole.

Failure when fighting a global recession, a global balance sheet adjustment, a global banking recapitalization, debt deflation and very possibly actual deflation can take many forms.

“It’s very hard to calibrate and it’s awfully easy to overshoot or undershoot, both of which would be disastrous,” said Lena Komileva, London-based strategist at Tullett Prebon.

Under clubbing the response to falling prices means you could slip into a self-reinforcing deflation, making your debts, be they consumer, housing or government, heavier and setting up a cycle where businesses and consumers defer consumption and investment.

Over-reacting risks fomenting a new bout of inflation and potentially causing a new bubble. (Who knows what that would be — dirt, water, baseball cards?)

And remember too, when deflation was last an issue on this scale globally during the 1930s, the global economy was nowhere as near as integrated.

As for now, the signs are clear: deflation is a growing threat in much of the world’s economy, though still to be sure not the central forecast.

U.S. producer prices dropped by 2.8 percent in October, the largest decline on record. Core intermediate goods and core crude goods prices, which show inflation at earlier stages in the production cycle, fell by a big 1.7 and a staggering 17 percent, respectively.

Consumer prices, which are usually sticky on the way down, fell at a record rate in October, down one percent and even falling by 0.1 percent in the month when plunging food and energy prices are excluded. That will kill corporate profits and shows a business community racing with consumers to see who can capitulate fastest.

HERE, THERE AND EVERYWHERE

Inflation is falling rapidly in Britain too, with overall consumer price inflation down 0.2 percent in October, the first monthly fall since the annual January sales and the first in October since 2001, just after 9/11.

Japan meanwhile has slipped back into recession, domestic demand is weakening, wages are falling and deflation may develop some time next year, a scenario Barclays Capital rates as a 40 percent chance.

Even China, where inflation has tumbled to 4.0 percent in October from a 12-year peak of 8.7 percent in February, has moved its focus to averting deflation.

Be in no doubt, central banks have the tools to fight deflation; while interest rates can only be cut so much, officials can step up the quantitative easing now happening, they can commit to hold rates at zero for an extended period of time, they can drive down their own currency by purchasing foreign bonds or finally, simply print money and drop it from the famous helicopters.

The issue is not the tools, but the speed of the printing presses or size of the bond purchases needed to get the right result, especially when it is interacting with what will be huge tax cuts and deficit spending.

A mix of monetary and fiscal policy will work, but it’s got to be the right mix and it has to be reasonably well coordinated internationally.

None of this is without risk. Remember the last deflation scare in the U.S. in the early part of this decade, which in retrospect caused the monetary bubble which was nursemaid to the housing bubble.

Print money or borrow excessively and you could lose the confidence of the currency market and experience a run, which certainly will help to fight deflation but is no-one’s idea of good policy.

In theory the amount the state will need to borrow will be in part offset by the amount individuals save, or more to the point pay down in debt and decline to invest privately. That theory will be put to the test by the number of governments who are going to be selling a very large number of bonds, which will after all have to be paid back.

Next year is looking as if it will be as unconventional as it is scary.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

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