James Saft

Will bond investors keep faith with U.S. government debt amid signs of growing global inflation?

In the end, as with all banks, even central banks, it boils down to trust.

Asked on Wednesday at an appearance before the U.S. House of Representatives Budget Committee if the Fed’s $600 billion programme of quantitative easing amounted to monetization — that Peter to Paul transfer when a government prints money to pay for a shortfall — Ben Bernanke said an interesting thing:

“Monetization involves a permanent increase in money supply though money creation. (QE) is a temporary measure that will be reversed. Money will be normalized and there will be no permanent increase in outstanding balance sheet or inflation.”

So, because he intends to undo it later, he’s not doing it now.

This is both demonstrably false and deeply, at least for now, true.

False because, of course, money is being created to fund the purchase of debt issued by the Treasury. True because Bernanke can avoid the disaster often associated with monetization so long as he retains the faith of the world’s investors that he not only intends to unwind QE but will be able to do so at the right time in the future.

Monetization is an inflammatory term because so often in the past the practice of funding a revenue shortfall by buying debt with newly printed money has worked out poorly, resulting in an inflationary spiral that beggars creditors and kills the real economy.

You can bet your last Confederate dollar that all the previous central bankers who bought their own bonds with their own printed money promised that they too would withdraw before it was too late. And some of them actually did withdraw the extra money, including some of Bernanke’s predecessors at the Fed during and for a time after World War II.

Daniel Thornton, a vice president at the St Louis Fed,  suggests a slightly broader but still self-referential definition of monetization, in essence saying that it can only be judged not by action but by comparing a central bank’s performance against its targets. <http://research.stlouisfed.org/publications/es/10/ES1014.pdf> That is well and good, but really leaves investors with nothing to rely upon but faith.

NO SIGN OF PANIC
So far, at least, the signs are that the world’s bond buyers believe Bernanke; so-called 5yr5yr forwards, a measure of inflationary expectations in five years’ time, show an uptick of about a percentage point since QE2 came on to the agenda last August, but only up to a pretty tame 2.8 percent or so. It is likely that some of that move represents rising risk of runaway inflation, but it also reflects rising confidence in growth.

Despite medium- and long-term concerns about the budget and the economy, Bernanke is in a reasonably strong position; he represents the world’s largest economy and its principle reserve currency.

That said, the loss of confidence, if it came, would be swift and devastating, more all of a sudden than little by little.

While Bernanke’s recent comments give little indication that a rethink of QE is coming soon, his colleagues are now sounding a lot less enthusiastic.

“Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases,” Dallas Fed President Richard Fisher, a noted hawk, said in a speech on Tuesday.

“I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.”

Fisher goes on to blame Congress for creating the debt, but the message and fear are clear: monetization should be rolled back.

In speeches the same day, Jeffrey Lacker of the Richmond Fed recommended that the Fed consider adjusting QE in light of improving data while the Atlanta Fed’s Dennis Lockhart said he thought no more bond buying would be needed after the expiry of the current $600 billion plan at the end of June.

Those are still minority views, and will be until Bernanke changes his tone. Given the very mixed signals coming out of the U.S. jobs market, don’t expect that to happen any time in the next month. Remember too what happened last year, when the Fed stepped back from QE1 only to see the economy weaken undesirably as the year wore on. Markets only revived once Bernanke all but promised another round of bond buying at the end of August.

For now, the controls are still in Bernanke’s hands, but keep watching the bond market.

(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. email: jamessaft@jamessaft.com)

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

Apparently not satisfied with being unable to fulfill its dual target of price stability and maximum employment the Federal Reserve has set itself a third mandate: higher asset prices.

Speaking on CNBC at a Federal Deposit Insurance Corporation-sponsored forum on small business lending last week, Fed Chairman Ben Bernanke was asked how, in essence, his $600 billion quantitative easing programme could be called a success when interest rates and commodity prices had actually risen in response.

“We see the economy strengthening, its gotten better over the last three or four months, a 3-4 percent growth number for 2011 seems reasonable,” he said.

“Our policies have contributed to a stronger stock market, just as they did in March of 2009, when we did the last iteration (of quantitative easing). The S&P 500 is up about 20 percent plus and the Russell 2000 is up 30 pct plus.”

So, there you have it; the man who controls the printing presses congratulating himself for driving stock prices higher.

First off, this is a very low hurdle of success. It is a bit like playing battleships in the bathtub and calling yourself a great admiral for pulling the enemies’ ships under the water.

We know he can do it — as he says he has done it in the past. The question is: should he?

The theory is that higher asset prices, particularly rising asset prices, will help to restore confidence and will entice greater investment and consumption.

Consumers, feeling a bit richer, will spend a bit more, and businesses will respond by committing to investment in new capacity to meet new demand.

Money parked on the sidelines will go from feeling smart to feeling stupid and will move into riskier assets like stocks or high yield bonds.

On this analysis, Bernanke and his supporters on the Federal Reserve are exactly right, some of the money that is summoned from the ether by rising stock prices will be spent and that once notional cash will have a real impact.

But really, how well did this work out the last couple of times it was tried, first in the 1990s and then again in the last decade? Not well.

Many Americans committed to spending programs that their earning power really wouldn’t support and huge and insupportable debts were created in the process. The dotcom and housing bubbles were produced and duly burst, and each successive bubble dealt deeper damage to the financial system and global economy.

KEEPING IT SIMPLE

While we have known for months that the Fed was targeting asset prices with QE, it really is shocking to hear it enunciated so clearly.

As money manager John Mauldin mused in a letter to clients, would the Fed be setting targets for shares? Were there other assets it would like to target?

The Federal Reserve is deeply compromised by doing this; it is two thirds of the way down a slippery slope and the mud is starting to fall from above.

The policy may not work and may have considerable unintended consequences, as hinted at by Philadelphia Fed President Charles Plosser in a speech on Monday.

“The notion persists that activist monetary policy can help stabilize the macroeconomy against a wide array of shocks, such as a sharp rise in the price of oil or a sharp drop in the price of housing. In my view, monetary policy’s ability to neutralize the real economic consequences of such shocks is actually quite limited …

Attempts to stabilize the economy will, more likely than not, end up providing stimulus when none is needed, or vice versa. It also risks distorting price signals and thus resource allocations, adding to instability. So asking monetary policy to do what it cannot do with aggressive attempts at stabilization can actually increase economic instability rather than reduce it,” Plosser said.

Perhaps even more disturbing is the idea that the Fed’s bathtub play with stocks and shares opens it up to outside pressure which could fundamentally undermine both its reputation and independence.

As was the case with its decision to direct capital to specific sectors of the economy, bubbling asset prices will be viewed by people like new Congressional Monetary Policy subcommittee Chair Ron Paul as an infringement of Congress’ traditional control of the purse strings.

When it comes to purchasing securities the line between fiscal and monetary policy becomes all but meaningless, and so the Fed’s action is a counterweight to inaction by Congress and the Executive branch.

More stimulus may well be what the economy needs, but if true it needs it from the fiscal side rather than by encouraging more share holders to spend more money they haven’t really got.

(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.)

The good news is that the European Central Bank will probably start a massive additional round of quantitative easing to fight the break-up of the euro zone.

The bad news is that they will, as ever, only choose the right policy, as Winston Churchill said of the Americans, after exhausting all of the alternatives.

Global share markets rallied furiously on Wednesday, fed by hopes that the ECB would increase its bond-buying efforts, a possibility raised by its chief Jean-Claude Trichet in an appearance before the European Parliament. Trichet faces stern opposition inside the ECB from fellow central bankers, notably German Axel Weber, who believe that policy should be normalized rather than loosened.

This opposition, in combination with an unsure political climate, means that euro zone authorities will probably continue to try to buttress, enlarge and formalize the bailout mechanism while trying to maintain the fiction that something approaching normality reigns in European money and bank funding markets.

Why would QE be used to fight the break-up of the euro zone, now being widely discussed as the crisis spreads to ever larger member states?

Because QE, or really we should simply call it the monetization of government borrowing, offers some hope of easing the austerity now being imposed on Ireland and soon to come in Portugal and Spain.

Europe has made a choice to not allow member states to default or to allow their weakened banks to default, as default would threaten banks elsewhere. That leaves weakened economies carrying a crushing amount of debt, debt they will attempt to repay by budget cuts. This is a recipe for an economic death spiral, as a smaller and smaller economy becomes less and less able to shoulder its debt service.

Without their own currencies to devalue, the weak of Europe have no other safety valves.

While QE is genuinely dangerous, it will ease conditions and can be directed at peripheral bond markets.Default is a better option, but Europe is unwilling to go there, at least not yet.

So, QE it will be, but the issue becomes when and how large.

“If the political masters in Europe wish to maintain the status quo then the answer lies in the monetization of debt. The ECB, with the ability to print money, can support the market by buying government bonds,” Stefan Isaacs, of fund manager M&G Investments, wrote in a note to investors.

“However what is needed is ‘shock and awe’ rather than tentative, reactionary responses, if indeed the ultimate goal is to support the euro in its current guise. That said, I’m not convinced that an about-turn is likely any time soon. The hawks in the ECB remain, for now, firmly attached to their mandate of price stability.”

EUROPE LOOKS FOR A BAZOOKA
For now, the ECB is likely to do what it can by way of bond purchases and liquidity support while temporizing over the pace and scale of returning the system to normality.

The focus of action, then, will be on increasing the size and prestige of the European Financial Stability Facility,  created in May and so far employed to help both Greece and Ireland. ECB council member Weber suggested in November this could be increased and there have been some indications that both the euro zone and IMF are discussing this.

This strategy is appealing to Weber and to others in Europe because it emphasizes euro zone strength and resolve, taking real money and lending it to allow member states time to pay back their debts, rather than printing up a mess of inflation and euro weakness to ease the pain.

A muscular strategy, but also a failing one. The 750 billion euros was meant to be big and intimidating back in May, but now looks paltry. If Spain needs help would 1.5 trillion euros look much better? Not if the debts of the weak Spanish regional banks are not partly extinguished. The same math of austerity and growth that applies now to Ireland will apply to Portugal and Spain in time.

So, QE, preferably large, from the ECB, but likely not until they are pushed early next year.

If this happens, or rather as its likelihood rises, it will drive a massive rally in risk assets and drive even more liquidity to Asia. Many investors will be giddy that the ECB and Federal Reserve are both driving asset prices higher, while a substantial minority, fearing inflation, will flee government debt and buy energy, commodities and gold.

The big loser, in the near term, will be China, which will have to eat European- and U.S.-exported inflation and will fret over its trillions in euro and dollar reserves.

(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.  email Saft at: jamessaft@jamessaft.com)